The Power of Compounding : The 8th wonder of the world - The Comprehensive Minds

The Power of Compounding : The 8th wonder of the world


Power of Compounding

Power of Compounding

Hello friends, welcome back. In this article, we will discuss one of the most powerful forces of the world, which is the power of compounding. So, read this article till the very end. 


What are the most powerful forces of the universe? When someone asked us this question, a few of the universal powers like the Sun, gravity, the black hole come to our mind. The power of compounding is also one of the most powerful forces in the universe. Albert Einstein has described the compound interest as the eighth wonder of the world. 


Warren Buffet, one of the greatest investors of all time, has said the power of compounding is one of the reasons for his wealth creation. He said, my wealth has come from a combination of living in America, some lucky genes, and compound interest. 


Before discussing any further, let's first understand what is compounding with the help of a simple example. You go for an interview in a company; HR gives you two options for your monthly take-home pay. 


Option A is to get a fixed salary of $5000 per month for the next 30 months. And option B is to get $0.01as a salary in the first month and then in each subsequent month, the salary grows twice of the salary taken in the last month, meaning your salary would be $0.01 in the first month, $0.02, in the second month, $0.04 in the third month and so on. 


Which option would you take? Which one will give you the maximum benefit? Take a minute to think. Here are the answers. In option A, you get a dollar of $5000 per month for 30 months. So at the end of 30 months, you'll get a total salary of $150,000. 


What happens in option B? In option B you get a total salary of $10.7 million. Yes, you heard it correct, the number is $10.7 million. This is because of the magic of the power of compounding. And this option, your salary doubles every month. 


So for the first few months, you get a salary which is much less than option A in the 20th month your salary becomes equivalent to salary in option A. And then your salary keeps on doubling every month. At the end of the 30th month, you get a salary of $10.7 million. Notice a few things, out of the $10.7 million, $5.4 million comes in the 30th month. Here are a few important points to remember. 


The impact of compounding is less in earlier months and magnifies significantly in the later period. Since the impact is low in the earlier periods, it is not easy for people to realize the impact of the power of compounding. This is the main reason why people are not able to hold on to their good investments for a long period of time. 


Charlie Munger one of the greatest investors of all time, Charlie Munger has said, "Understanding both the power of compound interest and the difficulty of getting it is the heart and sole of understanding a lot of things. The big money is not in buying or selling, but in the waiting." We hear many people talk of stock trading, intraday trading, technical analysis, and technical trading, playing with derivatives like options and futures.

 

These trading activities may give us small profits at times, it is not always easy to get profit from trading, we may get small profits from our trading activities, but the actual wealth creation is investing in good quality stocks and waiting and waiting and waiting, then you see your wealth increasing over a period of time because of the magic of the power of compounding. 


The power of compounding is driven by two factors, one is the rate of return or the interest rate and the second one is the time period. Let us understand both of them one by one. You have three investment options to invest $1000 today. The first one is to invest in a fixed deposit earning 5% per annum.

 

The second is, invest in a mutual fund earning 10% per annum and the third you have an option to invest it in a stock or equity share, generating 12% per annum. Here is the table showing the value of their investments after 10, 20, 30, 40, and 50 years. 


mutual fund earning

The value of fixed deposit invested today at 5% per annum becomes $11,467 after 50 years. So after waiting for 50 years, your money grows almost 11.5 times when you invest in a fixed deposit. In a mutual fund, your investment grows $117,000 say your investment grows at the rate of 10% per annum and becomes 117 times in 50 years. 


In equity, your investment becomes 289 times after 50 years. If you look at this table closely, the difference in returns of mutual funds and equity shares is just 2%. But after 50 years, the value of equity shares is almost 2.5 times the value of mutual funds. Even a small difference in interest rates can result in a large difference in values over a period of time. Therefore, the rate of return is very important when you make any investment decision. 


Let's understand the impact of the time period. Taking our previous example, here we have the value of equity shares at the end of 10 years to 50 years. In this table, we see that the power of compounding is less in the initial years. 



Also Read: How Do Insurance Companies Make Money and How Do They Work

So from 10 years to 20 years, your value of the investment grows from $3,000 to $9,000 or $9,646. But this impact amplifies with the increase in the number of years. If you look at the investment value, at the end of 40 years and 50 years, the impact is much larger, at the end of 40 years, the value of the investment is $93,000 and it becomes $289,000 after 10 more years. Therefore, the time period is an important driver of the power of compounding. 


Let's look at another example. There are two friends Mr. A and Mr. B. Today, they are of 25 years of age and both of them want to retire at the age of 45. They decide to make some investment for their retirement. 


So the investment amount is $100,000. And the rate of return is 20%. But Mr. A invests this amount today and Mr. B invests this amount after five years. So the total investment period for Mr. A from today to reaching 45 years is 20 years, whereas the total investment period for Mr. B is just 15 years.


investment period

Let's see the value of the investment when they retire. The value of an investment for Mr. A becomes$3.8 million, whereas the value of the investment at the end of 15 years becomes$1.5 million for Mr. B. This is because he has remained invested for five less years, compared to Mr. A, both the initial investment and the rate of return is the same, but the investment period is different. 


And this is the reason why the value of investment of Mr. A is more than twice the value of the investment of Mr. B. To get the same value, Mr. B would have to wait for 5 more years. That is, redeem his investments at the age of 50. If Mr. B keeps his investment for another five years, its value would become 3.8 million. 


That is the same as the value of investment of Mr. A, but by that time, the value of investments of Mr. A would become $9.5 million. This is because as the period of investment increases the impact of compounding increases. 


Therefore, as an investor, you just need to start early and learn to be disciplined and patient. The earlier you start investing the greatest will be the wealth creation from the power of compounding. 

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