The Magic of Compounding

Napoleon Hill author of best seller ‘Think and Grow Rich’ is often credited as saying that ‘Make your money work so hard for you; so that you do not have to work for it.’ Various books have been written on the art and science of making money based on more or less the same principle.

Mathematically speaking ‘Make money work for you’ is called as compounding or simply compound interest. Albert Einstein was amazed by the power of compounding and called it the eighth wonder of the world.

The only way to attain the wealth you desire is to spend less than you earn and to save the difference. The rich are not rich because they earn a lot of money; the rich are rich because they saved a lot of money. Those who become wealthy do so by spending less than they earn. There is no other source of saving, and, by extension, of building wealth.

If saving is the key to wealth, then time is the hand that turns the key to unlock the door. There is no reliable method to quick riches. There are, however, proven methods to get rich slowly. If you are patient, and if you are disciplined, you can produce a golden nest egg that will hatch later in life. It might appear that the pittance you save now could not possibly make a difference, but that is because you haven’t considered the extraordinary power of compound interest.

Before we move on to identifying financial goals and how to achieve them it is important to understand the power of compounding and regular saving.

Understanding Compounding

Regular saving in relatively safer financial instruments yielding moderate returns can work wonders over a long period of time. If a parent starts saving Rs 25 daily for their child from the day he or she is born for the next 25 years at a rate of 10 per cent compounded annually, they would be able to gift the child an amount of Rs 9.25 lakh on his 25th birthday.   

Apart from the money the amount will teach the child the advantage of savings. If he learns to save and invest in the same way as his parents and starts saving Rs 3,000 per month religiously in the same instrument earning 10 per cent compounded annually he would be able to get an amount of Rs 1.02 crore at the time of his retirement (60 years).

Compounding works wonders over longer period

Wealth cannot be accumulated overnight, like a tree it needs to be nurtured. Compounding teaches us that it does not take too much of money to save a decent amount. What is required is the discipline of regular saving and time on your side. Longer the time better will be the return.

Take the earlier example of the parent saving Rs 25 daily for a period of 25 years. In order to get the same amount in a span of five years they would have had to save Rs 400 every day. If the parents had saved Rs 150 every day for a period of 10 years they would have been able to save around Rs 9 lakh.

Another way of looking at the above example of retirement planning is that the amount of Rs 3,000 per month saved for 35 years, from the time he starts saying to his retirement, will earn the person Rs 1.02 crore. This is equivalent to receiving Rs 34,000 per month for the next 25 years of his retired life, assuming that the entire amount of Rs 1.02 crore does not earn any more interest post his retirement. In reality the amount of Rs 1.02 crore itself will be earning an interest of Rs 10 lakh per annum if it is invested in a fixed deposit yielding 10 per cent return, which would work out to Rs 83,330 per month.

In other words a small saving at a time when you are working and can afford to save can result in good revenue at a time when you yourself are not earning. This is what Napoleon Hill meant when he said to make your money work for you.

Impact of interest rate on compounding

It is a no brainer to suggest that higher the interest rate higher will be the returns. But interest rates have a magical impact on returns.

We will go back to the parent’s example to understand the impact of interest rates. Assume the same Rs 25 per day is kept in the savings bank earning 4 per cent interest. At the end of 25 years the parent would have been able to give their child a gift of only Rs 3.81 lakh. If on the other hand they would have invested in an 8.5 per cent instrument the return would have been Rs 7.35 lakh. While a 12 per cent instrument would have given them a higher amount of Rs 12.65 per cent.

However, as interest rates rises so does the risk. Higher yielding returns are possible only from riskier instruments like equities.

The problem with higher returns are that they are not steady and predictable in nature. Because of this unpredictability element they are difficult to work with in long term planning. There might be number of years when the return would be negative which would be counterproductive for the purpose.

Compounding and goal planning

Financial goal planning has to be on a steady and predictable return. Starting to save early in life prevents us from taking riskier bet. It is harder for your savings to catch up with your needs if you start investing later.

How to get rich slowly

You can make compounding work for you by doing a few simple things:

1. Start early: The younger you start, the more time compounding has to work in your favor and the wealthier you can become. The next best thing to starting early is starting now.

2. Make regular investments: Don’t be haphazard. Remain disciplined, and make saving for retirement a priority. Do whatever it takes to maximize your contributions.

3. Be patient: Do not touch the money. Compounding only works if you allow your investment to grow. The results will seem slow at first, but continue on. Persevere! Most of the magic of compounding returns comes at the very end. Compounding creates a snowball of money. At first, your returns seem small; but if you are patient, they will become enormous.