Wealth is not created by earning windfall income once by speculation or gambling. Creating wealth is an art, and it can only be attained by skilful handling of one’s resources. Patience and discipline lead to wealth management and creation. No matter how small an amount you set aside, it all gets accumulated in the ocean you want to see. We all tend to ignore the power of compounding which is the only accelerator of building up a great corpus.
The great Albert Einstein once pointed out that “Compound Interest is the eighth wonder of the world. He who understands it earns it. He who doesn’t pays it.”
What is Power of Compounding? & How Power of Compounding Calculator Work
Simply put, it means earning interest on interest. It leads to geometric growth in your investments and savings. You can start with a small sum as the key is not the initial investment but the duration of investment. Let’s see how a yearly investment of Rs 10,000 will grow year-on-year at different interest rates:
From the above table it can be easily understood that if somebody invests Rs. 10,000 at the beginning of year 1, it would take him 10 years to triple this sum at compound interest of 12% p.a. During the same time, the amount will double when invested at the rate of 8% (a rate at which traditional instruments yield returns, such as PPF, FD, RD, and more).
Benefits of Compound Interest in the Long Term Investment
Let us see what the magic of compounding can do in a longer horizon.
Rajiv, an IT engineer, invested Rs.5000 @ 8%at the age of 30. He wanted to retire by the age of 60 and was saving for his retirement corpus. Take a look at how his investment will perform under simple and compound interests.
Now we can well understand if just one time investment can become this, then what wonders can happen if systematically a little is set aside every month or even every year.
See how a yearly investment of INR 5,000 will grow over a span of 30 years.
Though annual investment remains same, the compounded return does not increase proportionately. The returns are accelerated now, though Rahul is investing just INR 5000 a year. His earlier interests are getting re-invested every year to earn for themselves. The longer the duration of the investment, higher the growth in returns.
After experiencing this benefit Rajiv discussed this with his junior Rahul a new joinee in his organisation. He wanted Rahul to be pro-active and start investing right ahead and do not repeat the mistake which he did. Rahul is now 20 years old and Rajiv is 30 years old both have 40 years and 30 years, respectively to retire. As Rahul is planning to start early we can very well guess that he will be better off than his senior. But to make the situation even more interesting let us assume that Rahul plans to invest INR 5000 for the next 20 years and then leaves his accumulated corpus to grow till he reaches the age of 60, whereas Rajiv invests for the entire tenure of 30 years till retirement.
This example is being taken to check the time effect. Every year is precious. At times, we defer investment to meet our discretionary expenditure believing that we may start investing next year. And how does it matter if we start a year later.
Rahul invested for 10 years less than Rajiv, which means his contribution was Rs.50,000 less than Rajiv. But when we check the returns, it is astonishing. For the remaining amount invested for 30 years, Rajiv gets a little over Rs.6,00,000, but Rahul gets nearly Rs. 14,00,000. The difference in investment is Rs.50,000 but the difference in returns is Rs. 8,00,000.
So now it is clear what the magic of compounding can do to our money. If we start investing early, money would start earning for itself.
Thumb rules of investment
- Start Early: Without procrastination if someone starts early investment, he will be able to see his investments grow and make his post retirement period a very smooth one. With early investment I mean the time one starts earning. Earmark a percentage of your income and swear to invest it. If you have not started investments yet, start now. Do not wait for the right time, make time right for yourself. Postponing savings can make it difficult for you to reach your destination. It is not important how much you save, the earlier you start saving is important. Early bird catches the worm.
- Be regular: Regular investments make your portfolio healthy. Disciplined and dedicated contributions work best to create wealth. Define priorities. I have heard many people saying that with this little income I am not being able to meet my needs how can I think of investments. For them I only have one suggestion, think that you are getting 10% less salary. This means if you are earning say Rs. 10000 a month, think that your salary or income is Rs.9000. Invest this Rs.1000 and you shall thank me later in life.
- Patience is the name: This is the most important ingredient of wealth creation. Panic spoils it. Power of compounding is felt and seen only if investments are allowed to grow at its own pace. It may seem that investments are not growing, but after few many years of dedicated and disciplined investment you may be surprised to see what compounding does to your portfolio. In a nutshell, leave your money alone.
- Improve your spending habit: In this materialistic world there is no end to human demands. Today we buy this and then we plan for something else. A person who starts saving early in life develops a habit of thrift, and focuses on his budget before indulging in something that is not a priority or an essential good which he cannot do without. Don’t be impulsive be compulsive buyers.
Power of compounding calculators are easily available online, these calculators thus help you assess how much you need to save to reach a specific desired figure.
All the variables such as time, rate of interest and future desired figures can be selected and chosen by an individual. This is because all of us have different goals and to achieve our individual goal we need different plans.
Simply stated, compound interest means that you earn interest on the original amount you’ve saved, and then you continue to earn interest on interest. This phenomenon goes on and on-packing your savings with power and moving you steadily toward your savings goals. Over time the results can be dramatic.
To achieve lifetime financial security, you want your money to grow many times larger than its original value. With the power of compounding at work, you can easily know when your money would be double.
Rule of 72 helps you to check out when you can double your investments. It is simple all you need to know is the rate that you earn on your investments. Say the rate is 8%, and then simply divide 72 by 8. The result is 9. Which means your sum would double in 9 years.
Even on a small amount you start saving, the magic of compounding works on that as well. The longer your money is invested, the better compounding works for you. The earlier you start the lesser you need to save for a goal. If we plan to buy a house for ourselves in two years then definitely we need to save a lot, and may be that saving too is not enough to help us reach the figure we desire. But if do it over a span of 10 years then probably the situation would be a lot more comfortable.