The power of compounding means interest earned on an interest that may not be understood by the human mind as we are trained to think in a particular manner. Compounding will help you achieve exponential wealth over a period of time. But before that, you must understand how it works, which is explained with different examples in this article.
Formula for compound interest (A) =P(1+r/n)nt
Where in, P = Principle
r = Rate of return
n = number of times interest applied per time period
t = number of time periods elapsed
There are three components in the formula principle Principle= Initial investment, Rate of return = Expected rate of return on investment, and Time= Time given for the investment to compound.
The above presentation is just a general description which is usually thought in school, but forgotten about its original powers & use.
Below are the famous quotes on compounding said by great men:-
“Compound interest is the eighth wonder of the world. He who understands it, earns it…..he who doesn’t….pays it”-Albert Einstein
How WARREN BUFFETT become the richest person on earth?
One of the tools he used is the power of compound interest. He turned a few hundred dollars into hundreds of billions of dollars.
When he started investing through BERKSHIRE HATHAWAY in the year 1965 share price was approx. $7.5 dollars and now it is more than $200000 a CAGR of 17% approx. each year.
The magic of compounding was on his side for more than 50+ years. So the most important component in the formula actually is the time because the principal amount of investment is limited with all & rate of return cannot be fixed by anyone whatsoever.
Power of compounding & investing in the stock market.
The Stock Market is actually a compounding machine. For eg.:- When the Sensex came into existence the index was at 100 points & now it is at 36000+ points approx. It is approximately doubling every 4 years from its inception I.e.15% CAGR approx.
Sensex is a composition of the top 30 companies, where the share of these companies is listed. A share is just a piece of business, when the revenue, profit, margins, etc. increases over a period of time along with the share price increases.
If anyone could find a company which can give a 10% return for the next 20 years & if he just invest $100000 in it, at the end of the 20 years period it will be worth $672750 without any efforts, by just sitting idle.
Vehicles for compounding.
(MUTUAL FUNDS, INDEX FUNDS, INDIVIDUAL STOCKS)
With individual stock is already explained above Investing through SIP (Systematic Investment Payment) If a person invested only $1000 for the next 20 years per month at 10% return the amount at the end of the 20 years period will be worth $7,73,025, but by just adding 10 years more it will come to $2,299,163 that’s the power of compounding. But again the most important thing is time, so start as early as possible.
One can easily invest a few bucks each month and retire with a decent amount of money. One of the simplest ways to do so is via SIP in a mutual fund or an index fund; this option is good for people who don’t want to study the market or business & who don’t have the psychological capacity to bare the market fluctuations. Hdfc compound interest calculator: https://www.hdfclife.com/financial-tools-calculators/compound-interest-calculator
Compounding & taxation.
There is also a capital tax benefit along with compounding in the stock market which means you don’t need to pay tax until you sell a stock. Which actually means you are borrowing money from the government for free. So one should stay invested for the long term in stock to take advantage of it.
The greatest story of compound interest.
This story dates back to more than 220 years ago & involves one of the most fascinating humans ever lived BENJAMIN FRANKLIN, he was an inventor, scientist, civic activist, diplomat, etc. He also was the Founding father of America.
Benjamin Franklin power of compounding story
He donated $1000 for 100 years & 200 years to his native hometown BOSTON & his adopted hometown PHILADELPHIA each with the condition that money be loaned @ 5% to young craftsmen with the following condition that:-
- He should be under the age of 25 years
- Who is married?
- He has completed his apprenticeship
- Can obtain two signores.
After 100 years both the town can use 75% of the funds for public works & continue to for the next 100 years, in the end, each city would get 25% of the funds & the respective state will get the rest.
If they would have done so the amount available with the city would have been $20 million at the end of 200 years. But due to wrong investment, political issues, etc. they actually we’re just left with 5 million with BOSTON & 2 million with PHILADELPHIA.
You can see the MAGIC OF COMPOUNDING from this example. THE MOST IMPORTANT COMPONENT IN THE EXAMPLE WAS TIME, SO ONE SHOULD START INVESTING AS EARLY AS POSSIBLE.
The magic of the compound is explained in great detail in this book. THE COMPOUND EFFECT -BY DARREN HARDY (A must-read to understand how compounding work in the real world and its benefits)