What is compounding ?

Compounding is another basic principle in finance.

Two cases to illustrate what compounding is :

  • Case  1 : A 25 year old who invests Rs 50,000 every year for 10 years will earn 8.77 lakhs , if he manages to get a return of 10% every year. And , then if he leaves that investment there until he’s retires at the age of 60 , he would accumulate around Rs 95 lakhs .
  • Case 2 :  A 35 year old guy starts doing this and invests Rs 50,000 regularly till he retires.  But he will manage to accumulate only Rs 54.1 lakhs which is around Rs 41 lakhs less in comparison to the first scenario.
  • What made the difference is the time factor.

5 simple points spell out from this story:

  • If you start late, you’ll manage to get a corpus which is 43% less.
  • Why? Because, in case 1 ,  Rs 5 lakhs ( Rs 50000 x 10 years ) was allowed to compound for a longer period of time.
  • As the fund grows, the impact of compounding is greater. In case 1 , he accumulates 50,000 for ten years, stops at 35 and then, his 8.77 lakhs (5 lakhs + Interest) is allowed to compound for 25 years till he’s 60. Whereas in case 2 , he starts at at 35 and invests Rs 50,000 for the next 25 years, accumulates 12.5 lakhs (50,000 x 25) only to get 54.1 lakhs at 60.
  • Now let’s assume that inn case 1 , he  had allowed the fund to compound for only 20 years i.e.  Till he turned 55. At 10% return every year, he would have accumulated an amount of around Rs 59 lakhs. By choosing to let his investment run for last 5 years, he accumulates Rs 45 lakhs more.
  • Essentially, compounding is the idea that you can make money on the money you’ve already earned.

Easily said ! isn’t it?

I know it generally doesn’t work as i said. Because at 25, most of you haven’t drawn a plan to invest 50,000 a year. Even if you’ve done it , somewhere down the way , you’ve missed to add to your corpus regularly year after year or due to some emergency that crept in, you took back some amount from the corpus and din’t let your money grow !

So , how can a common man use this to his advantage?

Always remember to reinvest. Whether it is  interest or dividends received on your investments. Over a period of time, such small amounts will add up to a tidy sum.

Here’s more :

  • Savings of Rs 2500/- per month with 10% return will be worth Rs. 56 lakhs after 30 years.
  • Savings of Rs 5000/- per month with 10% return will be worth Rs. 1.91 crores after 35 years.

Note : The above are not typing errors ! 🙂

Here is a comparative chart for you to understand.

Let’s assume that you invest Rs 10,000 annually. Your retirement age is 60. Let’s also assume that the interest rate you get is 10%.

At the age of 60 you will have –

  • 49 lakhs -if you had started investing from age 20.
  • 30 lakhs -if you had started investing from age 25.
  • 18 lakhs – if you had started investing from age 30.
  • 11 lakhs – if you had started investing from age 35.
  • Just 6 lakhs – If you start at 40. Take note of the impact.

That’s a huge difference, right ?  Now that you realized it late, what can you do? You can start now, invest more and reach the target of 49 lakh at age 60. This would mean more hard work and budgeting for you.   Let us see how much more you would need.

To get 49 lakhs at age 60 –

  • Invest 10,000 annually – at age 20
  • Invest 16,500 annually – at age 25
  • Invest 27000 annually – at age 30
  • Invest 45,000 annually- at age 35
  • Invest 78,000 annually – at age 40!!

Generally what I find is that most of the Indians start thinking of saving and investing at the age of 30-35. The above calculation is made assuming that the interest rate you get is 10 percent. But the average interest rate of banks is less than that. I hope the picture is now clear for you. The more you delay, the more you need to invest.

 

1 comments On What is compounding ?

  • Wow Jins what a great case study you have presented in the starting of the article. I am just blown away. That is the real power of compounding. I remember reading Balaji vishwanathan’s answer in Quora that in which he said compounding is the 8th wonder of the world

    Also, you beautifully illustrated the power of compounding in the rest of the article. I am just loving your content. Thanks for such an awesome website 🙂

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