What is Power of Compounding and How does it work?
Compounding in mathematical term would simply mean “Make money work for you”. Even the famous scientist Albert Einstein was so amazed by compounding that he called it to be the eighth wonder of the world.
But before we understand how does the power of compounding works or how to identify financial goals, let’s understand the basics of compounding.
What is compounding?
Compounding is the mechanism of generating earnings on the reinvested earnings of your asset. It works on two basic concepts:
1. Reinvestment of earnings, and
2. Passage of time.
Also see: What is Power of Compounding and How it works? In Hindi.
How the power of compounding works in real life?
An uncle of mine invested Rs 1000 in one of the company in the year 1980 and bought 10 shares of face value of Rs 100. The same 10 shares became 9,60,000 shares by the end of the year 2015. Any guesses, which is that company?
The company is Wipro and the present value of the portfolio is worth more than 100 crores. This is basically the magic of compounding i.e. higher the time frame, more the benefit from compounding.
Though investment in equity seems to give good return in the long term we should not forget the risk element associated with it. Hence a proper research is very important for equity investments.
Let’s have a quick analysis of the returns generated by various investment products like savings bank account gives a return of 4-6%, in F.D., we get around 8% and investment in equity provides a return of 10-15 % over the longer time frame depending upon the risk.
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The magic of compounding in nature
Let’s take a brilliant lesson from the extraordinary intelligence in nature. There’s a tree in far east named Chinese bamboo tree which has a very unusual growth pattern. While other trees grow gradually and steadily over the years, this tree doesn’t come out of the ground for the first 4 years, however, in the fifth year, it grows at an extraordinary pace and reaches up to the height of about 90 feet within 5-6 weeks.
What a brilliant example of patience!
The farmers who grew this tree have a faith that if they keep providing fertilizer and keep watering the ground, a day will surely come when the tree will break through.
The same logic can be applied to our equity investment as well. So if you keep patience and keep investing your money regularly in a disciplined manner, then after a particular point, you will surely be rewarded. But with equity investment, it’s better to think long term.
It’s always advisable to start early with things which take a long time to show its magic and equity is one such thing. Legendary investor Warren Buffett also agrees on starting early as he made his first investment at the age of 11 and was of the view that he started very late. Check out the fundamental analysis of stocks for more understanding .
Power of compounding for your kids
You don’t need to invest a lump sum amount to save for your kids rather investing a smaller amount on a regular basis in an instrument which provides moderate return is good enough. As a parent, you can simply start saving Rs 30 daily for your child from the day he/she was born at an average rate of 10 % compounded annually for the next 25 years. On his/her 25th birthday, you may gift him/her 12 lakh rupees (approx).
You should teach your kids about the importance and value of money and try to instill a habit of savings in them. The money your child will receive will teach them a lesson about the importance of savings. Similarly, if your kids start investing Rs 3000 every month from the age of 25 as a lesson learned from the parents, so he/ she would able to make Rs 1 crore at the time of retirement.
Power of compounding and averaging
The key to compounding is to start early and holding it for the long term. Starting to save early in life prevents you from taking bigger and riskier bet. It’ll be harder for your savings to catch up with your needs if you start with your investments in a later phase of your life.
Similarly, the power of averaging if combined with the power of compounding can create wonder. Power of compounding or dollar cost averaging in simple words, implies making a fixed investments in a security or portfolio of securities at a fixed interval irrespective of the market direction.
Let’s take a practical example as to understand how the power of both compounding and averaging really works. The image below (taken from Moneycontrol.com) illustrates the result made out of Rs 1000 invested every month starting from January 2000 till present date in Reliance Growth Fund.
Discipline and patience are the keys here in power of compounding and averaging. It is the commitment which is required to put aside a sum of money at a regular interval for the future need. Someone has rightly said-
“Starting is the hardest part…the rest will follow”
So, what exactly are you waiting for?
Author Bio: Mr Ankit Jaiswal – Knowledge Associate at Elearnmarkets.com. A commerce graduate from St. Xavier’s college, Kolkata . He strongly believes in the following saying by Warren Buffett-“Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it”