Power of Compounding:
In this week’s article, I will share my reading on Power of Compounding which has been termed as EIGHTH WONDER OF THE WORLD by ALBERT EINSTEIN.
In a layman’s language, Compounding is defined as “Interest on Interest” over a defined period of time.
How it Works : I would like to share a short story on compounding which will make it clear i.e. How Compounding Works !!!!
“There was once a poet who fell upon such hard times that he was no longer able to feed his family.
Hearing the king greatly encourages talent and was famed for his generosity, the poet set off for the royal palace.
When brought before the king, he bowed and asked that he may recite a poem.
On hearing his recitation, the king, well pleased, asked him to name his reward.
Pointing to a finely wrought chess board, the poet said “Your highness, if you place just one grain of rice on the first square of this chess board, and double it for every square, I will consider myself well rewarded.”
“Are you sure?” asked the king, greatly surprised. “Just grains of rice, not gold?”
“Yes your highness” affirmed the humble poet.
“So it shall be” ordered the king and his courtiers started placing the grain on the chess board.
One grain on the first square, 2 on the second, 4 on the third, 8 on the fourth and so on.
By the time they came to the 10 th square they had to place 512 gains of rice.
The number swelled to 5,24,288 grains on the 20 th square.
When they came to halfway mark, the 32’nd square, the grain count was 214,74,93,648 – that is over 214 crores.
Soon the count increased to lakhs of crores and eventually the hapless king had to hand over his entire kingdom to the clever poet.
And it all began with just one grain of rice.”
However, Practically One cannot double their money continuously for every year, leave alone every day.
Just to give you an idea, if you start with Rs.1 crore and double your money every year (100% annualized returns), you would have Rs.1024 crores after 10 years and Rs.10,48,576 crores after 20 years. How absurd and impossible the above number looks?
But people continue to fall for schemes which promise to double the money in the short time. If the persons running those schemes are genuine, they would be the richest in the world.
Warren Buffett, one of the richest in the world, has produced an annualized return of ‘only’ around 20% over last 6 decades.
We’ve seen in the past that Sensex has given around 17% annualized returns over long run.
Equity Mutual Funds in India have given an annualized returns in excess of 22.6% over the last 18 years.
The bottom line people forget is that for compounding to work meaningfully, one needs time. There is no short cut. Staying invested for the long time is the only way.
There is no short cut. Staying invested for the long time is the only way.
Taking the above figure of 22.6% annualized returns;
In 10 years, your money would have multiplied by 8 times
In 20 years, your money would have multiplied by 59 times
In 30 years, your money would have multiplied by 451 times
What a difference each decade makes to compounding!!!!
“Of Warren Buffett’s current $60 billion net worth, $59.3 billion came after his 50th birthday, and $57 billion came after his 60th. Compound interest works its wonders only in very long periods of time.”
A small sum invested every month from the beginning of your work-life can lead to a very impressive sum at the time of your retirement.
Time is the essence for the 8 th wonder, Compounding to work.
In Equities, time levels the bouts of under and over performance and produce optimum returns. Equities are predictable only over long term and short term performance or forecasts are of little use.
Hence, one should always remember the power of compounding and how well it works only over long term.