#007: On compound interest: the 8th wonder of the world!

Author’s Note
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In the far east, there is a tree called Chinese Bamboo tree that differs from many other species, in the sense that it doesn’t grow in a usual fashion.

While most of the trees grow steadily over the years, these Chinese bamboo trees don't break through the ground for the first four years. The twist comes in the fifth year. In the fifth year, in a period of about five or six weeks, the Chinese bamboo tree grows at an astonishing rate and reaches up to a height of 90 feet.

This is exactly how "Compound Interest" also widely known as the 8th wonder of the world works.

The growers of the Chinese bamboo tree must have some faith that if they keep watering and fertilizing the ground, there will be a day when the tree will definitely break through.

The initial years of compounding are very boring, just like the initial years of the bamboo tree, despite slogging and saving, the corpus would grow only slowly and big wealth would seem to be a distant dream. 

The effect of compounding starts to kick off only after years and then it picks up momentum. Patience and persistence are the key. Accumulating the first million is the most difficult task. Money is the seed of money. Once you reach a certain threshold and as long as you don't do anything foolish, you start experiencing the joy of compounding.

Compounding takes time, therefore, it’s always better to start early, let's understand why…

The classic phenomenon which separates compound interest from simple interest is that in compound interest, the interest from second year onwards is also earned on the interest which was generated in the first year and this process goes on and on, unlike simple interest in which interest is generated only on the initial principal invested.

Compound interest therefore creates a chain reaction by generating returns on the returns as long as your money remains invested in the financial instrument.

Why should you start early?

Take, for example, A who started investing ₹2,000 every month from the age of 25. Then there is B, who started investing ₹5000 per month when he reached the age of 35. When both A and B turn 45, on a realistic 12 per cent return, A's kitty will turn to a sizeable ₹20 lakh, while B's will be nearly half at ₹9.30 lakh, despite B investing more than A.

With age on the side of most youngsters, you can avoid the same predicament as that of B.

Let's see the power of compounding in the above illustration:

Total investment by both A and B is ₹4.8 lakh.
The difference is in the period of investing.

While A invests for 240 months, B invests for 120 months, but a higher amount.
For A, interest income earned comes to ₹15.20 lakh in a corpus of ₹20 lakh (nearly 76 percent) while for B it is ₹4.5 lakh in a corpus of ₹20 lakh (nearly 48 percent).

Compounding doesn't require you to be an excellent investor, it only demands consistency, let's see why…

Suppose you are able to generate a return of 18% annually in your equity portfolio. Investing ₹10,000 @18% and waiting for 30 years would fetch you a staggering ₹14.3 lakhs which is a 143x times return. In another case someone is able to generate a return of 25% on their investment of ₹10,000 but has a shorter duration of 20 years, the investor would be able to turn ₹10,000 into ₹8.6 lakhs which is 86x times.

Here is the formula which you can use to calculate potential returns from compounding

A=P(1 + R/100)^n

A= Amount

P= Principal invested

R= Rate of expected return

N= No. of years

In the above example,

1.43 lakh= 10,000(1 + 18/100)^30

Did you notice that difference? Even if you are an average investor but have a longer time horizon, compounding can do wonders for you and has the potential to turn a very modest sum into something huge and this is exactly the reason why there is no point in procrastination. So go ahead and INVEST, time is ticking!

Compound interest can create wealth for generations to come!

If ₹50,000 a month can turn into ₹35 crores in 30 years, imagine what it would do in 60 years. It would be ₹3,103 crores which is of course outlandish.

Nobody has that kind of money to save for their generations to come. But what if we saved just a little bit for them. Like ₹5,000 a month. In 65 years, it could grow to ₹653 crores (assuming 15% rate of return)

What if we did this for our future generations, and they did it for theirs? The wealth could compound, until the whole world was living with financial freedom. It starts with one person, but could later affect many.

Here are the 3 key rules of investment that helps you to get the true benefit of compounding:

1) Starting Early

There is nothing like starting early to make the most of compounding. If you start investing from the time you start earning, it will make a solid base for you that will enable your wealth to grow further over a period of time.

2) Discipline

If you wish to create a healthy portfolio, it is very important that you define your financial goals and be regular in your investments. Regardless of how less you earn, knowing what your priority is and understanding how being disciplined now would pay off later, will help you develop the habit to keep money aside for investing.

3) Be patient

A lot of us wish for quick returns and not realize that it is the long-term investments that really powerfully reap from the concept of compounding. You will have to allow your investment to grow at its own pace without meddling with it from time to time.

GenZ and Millennials may not have long-term goals on their radar, but that should not make them discard the savings process. They need to realize that along with their lifestyle expenses, the savings can also go hand-in-hand. The 'investing can wait' attitude needs to be overcome. Procrastination can be the biggest enemy of compounding. For all those who do not have the inclination towards financial matters, the savings process itself may pose perplexing questions such as how much to save, where to save etc. but that should not deter you to start the journey.

It is immaterial how much one starts to save. Even a small amount of savings can create a big enough corpus if invested for a longer time horizon. What is important is to keep investing on a regular basis and not disrupt the process by withdrawing from it. For youngsters even a beginning made by saving 10 percent of one's income can be a good start. Talking of Infosys as an example, just 1000 rupees invested in its IPO in 1995 is worth ₹20 lakh in the present.

That’s the power of compounding. Nothing can stop it from growing. As long as the investment is paying you interest, you can keep smiling at night, because you know that time is your ally. The longer time goes, the wealthier you get! You are getting wealthier by the second and you are making the money work for you when you are not at work! 

Really, it starts with you.
If you’ve been reading all the way through, you’re already better than 90% of the world.

That's it for today dear reader, may the time be always in your favour!