One of the most basic premises of investing is that your money multiplies manifold over time and this multiplication of money is normally referred to as the "Power of Compounding". The compounding effect of investing your money is perhaps one of the most important aspects to achieving long-term wealth. For it to work, you must be a long-term investor with lots of patience.
When you invest money, it earns interest (or returns). If you keep the interest invested, then it does not sit idle while only the original investment sweats it out. The interest earns interest too and then the interest on the interest earns interest again.
This is the beauty of compounding. That is what made great men like Warren Buffet extol the virtues of "compounding".
What does the power of compounding mean to an investor? Let us understand this with the help of an example. Mr. A, Mr. B and Mr. C are three friends with same background and age:
On his tenth birthday, Ms A's father gave him Rs100. He wisely invested the money that earned him an interest of 15% every year.
Mr. B won Rs200 as prize money when he was 16 years old. His friend, Mr. A, advised him to invest his prize similarly. When Mr. C earned his first salary at the age of 21, he salted away Rs400 in the same instrument as Mr. A's.
After reaching the age of 60, all three decided to withdraw their investments. Who do you think realized the most from his investment?
You will tend to think its Mr. C, right? After all, he invested four times the sum that Mr. A had invested. So what if he had invested the money ten years later? He did earn interest for 40 years after that. But think again. Mr. A made the most out of his investment, in fact, his Rs100 was worth Rs108,366. On the other hand, Mr. C Rs400 was worth only Rs93,169.
It simply means that the longer you stay invested the more money you will make.
Now you know why Mr. A made more money than Mr. B and Mr. C.
Let us try another one more example to understand the impact of interest rates.
Let us assume Mr. A, Mr. B and Mr. C invested Rs100 for ten years. However, all three of them earn interest at different rates. Mr. A earns 20% while Mr. B earns 15% and Mr. C manages a 10% interest rate.
What each one of them will have ten years hence?
Mr. A will have Rs619 while Mr. B will have Rs405. while Mr. C will have the least Rs259 in ten years. Have you noticed something though? While the interest rates differ by just 5%, in ten years the worth of the original capital, Rs100 would be vastly different.
That is another way of understanding the power of compounding or the power to grow exponentially.
There is one more interesting rule associated with compounding: The rule of 72.
The rule of 72 is an easy way to find out in how many years your money will double at a given interest rate. It is very simple, divide the number in the title by the interest percentage per period to get the approximate number of periods needed for doubling.
Suppose the interest rate is 15%, then your money will double in 72/15= 4.8 years. In case, the interest rate is 20%, then the money will double in 3.6 years.
Thus the moral of the story is the longer you stay invested the more money you will make.
The power of compounding when applied to the stock market can make you rich many times over and sooner than you can imagine. That is because historically, the stock market is known to give the highest return per annum over long term compared with the other investment instruments.
So, if you don't have an exposure to the stock market yet, start right now as according to the power of compounding, the longer you stay invested the more money you will make. (Source: Kotak Securities newsletter)
When you invest money, it earns interest (or returns). If you keep the interest invested, then it does not sit idle while only the original investment sweats it out. The interest earns interest too and then the interest on the interest earns interest again.
This is the beauty of compounding. That is what made great men like Warren Buffet extol the virtues of "compounding".
What does the power of compounding mean to an investor? Let us understand this with the help of an example. Mr. A, Mr. B and Mr. C are three friends with same background and age:
On his tenth birthday, Ms A's father gave him Rs100. He wisely invested the money that earned him an interest of 15% every year.
Mr. B won Rs200 as prize money when he was 16 years old. His friend, Mr. A, advised him to invest his prize similarly. When Mr. C earned his first salary at the age of 21, he salted away Rs400 in the same instrument as Mr. A's.
After reaching the age of 60, all three decided to withdraw their investments. Who do you think realized the most from his investment?
You will tend to think its Mr. C, right? After all, he invested four times the sum that Mr. A had invested. So what if he had invested the money ten years later? He did earn interest for 40 years after that. But think again. Mr. A made the most out of his investment, in fact, his Rs100 was worth Rs108,366. On the other hand, Mr. C Rs400 was worth only Rs93,169.
It simply means that the longer you stay invested the more money you will make.
Now you know why Mr. A made more money than Mr. B and Mr. C.
Let us try another one more example to understand the impact of interest rates.
Let us assume Mr. A, Mr. B and Mr. C invested Rs100 for ten years. However, all three of them earn interest at different rates. Mr. A earns 20% while Mr. B earns 15% and Mr. C manages a 10% interest rate.
What each one of them will have ten years hence?
Mr. A will have Rs619 while Mr. B will have Rs405. while Mr. C will have the least Rs259 in ten years. Have you noticed something though? While the interest rates differ by just 5%, in ten years the worth of the original capital, Rs100 would be vastly different.
That is another way of understanding the power of compounding or the power to grow exponentially.
There is one more interesting rule associated with compounding: The rule of 72.
The rule of 72 is an easy way to find out in how many years your money will double at a given interest rate. It is very simple, divide the number in the title by the interest percentage per period to get the approximate number of periods needed for doubling.
Suppose the interest rate is 15%, then your money will double in 72/15= 4.8 years. In case, the interest rate is 20%, then the money will double in 3.6 years.
Thus the moral of the story is the longer you stay invested the more money you will make.
The power of compounding when applied to the stock market can make you rich many times over and sooner than you can imagine. That is because historically, the stock market is known to give the highest return per annum over long term compared with the other investment instruments.
So, if you don't have an exposure to the stock market yet, start right now as according to the power of compounding, the longer you stay invested the more money you will make. (Source: Kotak Securities newsletter)
No comments:
Post a Comment