The Power of Compounding

Nov 9th, 20102 Comments

Compounding interest is the greatest mathematical discovery of all time-Albert Einstein

There once was a king whose daughter was very ill. The king announced to his people that whoever cured his daughter can marry the princess and ask for another reward. One young man came and cured the princess with his family owned secret remedy. The king was so happy that he anxiously asked the young man what else he wanted besides marrying the princess. The young man pointed to a chess board with 64 squares on it and said just put one grain of rice in the first cube and two in the second, four in the third, and eight in the fourth, and so on until the 64th square is filled up.

The king laughed and confirmed with him, if he really wanted rice grains and not GOLD !! The King did not realize what he agreed to at that particular time. By the time they reach 32nd cube, all the rice reserve of his Kingdom was exhausted, It was staggering 214 Crores grains itself… Each of the subsequent cubes required the King to double up the grains. King had to ask other Kingdoms for Grains and till he reached 45th cube, Rice Grains of all the kingdoms finished … Eventually the king had to handover his entire kingdom to this clever person.

Thats Power of Compounding !!

Compounding is a very interesting and powerful thing. It has great rewards in store for people who invest when they are young. If you invest later in life you will not be able to make use of the great “power of compounding

You simply need to be consistent in saving a portion of your money and let it compound over time. The fascinating effect of compounding gathers up momentum over longer periods of time and becomes an avalanche of wealth.

How does compounding work?

When you save Rs 100 and get an annual interest of 10%, you will have Rs 110 at the end of one year. Due to compounding the next year you will get a 10% interest on Rs 110, which will then leave you with Rs 121. The next year, interest will be calculated on Rs 121 at 10% and so on. In time, these savings will grow exponentially.

There are certain number rules that have been evolved to figure out a quicker method for calculations, especially in finance. Rule 72, is one such quick method of calculating how much time it will take, for your investment to double.

So, if you invest Rs 100 with a compounding interest of 10% per annum, the rule of 72 gives 72/10 = 7.2 years as the approximate time frame required for the investment to become Rs 200.

If you equate the same to a larger amount of Rs 1 lakh in approximately 7 years, it would grow to 2 lakh. Remember you will be consistently saving up too, topping up existing funds, hence, if you are planning to retire 60 years from the time of the investment, it will approximately snowball to about 6 times from its original value. This is the avalanche effect of compound interest.

Fortune favours the early bird!

Compounding interest is like wine, yields better results when money is saved over longer durations. So, if you are planning to save crores for your retirement funds, then start as early as possible, with your first salary or at least by 25 years of age. So, when you retire at the age of 60, you will be sitting on a comfortable pile of money to lead the rest of your life in style.

If you set aside a sum of say Rs 5,000 every month from the age of 25, at a return interest rate  of 10%, in 60 years you will have with you funds worth about a crore and more.

However, if you start at 40 with the same amount and return rate of interest, the retirement fund will amount to only around 33 L. That is a huge difference, the 40 year old individual would need to invest several multiples of Rs 5000 to be able to catch up!

Here is a comparative chart of the approximate retirement funds an individual can lay claim to depending on the age at which he starts saving.

Let us assume the individual plans to invest Rs 10,000, every year at a return interest rate of 10%. You will realize from the chart that starting early counts a lot!

You will notice from the above comparison, that even a matter of five years can make a huge dent on how much you retire with.

You could choose to start saving when you are much older and still meet the target retirement fund of 49 lakh, saved by an individual who started investing from the age of 20.

However, you will need to increase the amount of money you invest to make up for the lost time. This could be a strain on your budget, as you may have to set aside a significant amount of money to reach your goal.

All you need to reap the advantage of compounding interest and save up a significant retirement fund is to invest time, consistency, patience, and savings to obtain a financially secure future, when you need it the most.

Kevin Gala

2 Responses to “The Power of Compounding”

  1. Aditya says:

    Nice Article Kevin :-)

  2. Manish Nashikkar says:

    Really Good, Keep it up Kevin. All d best…

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