The magic of power of compounding [infographic]

The magic of power of compounding has been explained innumerable times by personal finance experts all over the world. Albert Einstein has very famously quoted the below on this concept – “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” And it cannot be farther from the truth.

Understanding the concept will help you make smart decisions early on in your life. There is not much fun in clearing the concepts when you are say, 5 years away from a big financial goal that you want to achieve and for which you have no money today. You should have started saving early on in life based on goal based investing concepts and the credit of the fact that it will work is based on the wonderful concept of power of compounding.

The problem with our education system is that they teach you right but they don’t necessarily teach you the practical aspects of what you learn. There is a concept of 70:20:10 of learning in a person’s life. It says that 10% of a persons learning is based on things he learns in his classroom – our schools that is. 20% of a person’s learning comes through mentoring. And 70% of the learning comes from learning on the job.

Now imagine applying that to personal finance. They teach the power of compounding to you in school but you seldom get mentors who will sit down with you and tell you to start saving early on in life, say from your very first salary. And if you have to learn on the job, then you must have already lost your shirt in the stock market in the process.

So if you reading this, and I would consider you lucky if you are less than 30 years of age as you have the biggest advantage of time on your hands to make most of the power of compounding, my humble request is to read this and talk to someone who can tell you practically how to implement the concept of power of compounding in your life.

The power of compounding explained

Imagine you love mangoes. Imagine that one day a fairy tale appears and gives you a mango seed. She tells you, you have two choices what to do with this seed. The first is to simply throw it away and forget about it as after all it is a darn seed left over by someone who ate the bloody mango. The second is to sow the seed with the expectation that the seed grows into a tree and produces some darn good mangoes; you then get to eat mangoes and plant more seeds resulting into more mangoes. The problem is that the latter option will take a long time, a really long time. And with investors looking for instant gratification, the option might not be a huge sales hit.

Some of you reading this will go with option one while others will go for option two. If you think back and contemplate, the second option is one that will make your future full of mangoes which you and possibly your family can feast on while the first one is a lost opportunity.

Compounding works similarly, just replace the mango seed with rupees. Let me explain.

You have some money on you, don’t you ? Let us call it the principal. Let us also say that the principal, aka the seed, generates a small amount of money called interest when you save it and invest it in an investment avenue – this is akin to generating more mangoes in the future when you plant the seed you have today instead of putting the seed in the dustbin. Imagine you keep on planting all the seeds that the future mangoes generate and you build a darn good farm of mango plants. That will we worth a lot in monetary terms. You have effectively built a huge mango farm from a single seed.

Let’s cut to the chase in monetary terms.

You have UnHappy Singh, OK Singh and Happy Singh. UnHappy Sing invests one time Rs 30,000 for 30 years which earns him  12% interest each year. The catch is that this is simple interest is money will be earning.

OK Singh, invests 1/3rd of what UnHappy Singh puts in for the same duration and this earns the same interest, the catch here again it that the money is earning compounding interest each year.

The results are amazing, although OK Singh invested a lot less (one third) of what UnHappy Singh put in, he ended up with twice the amount (Rs 2,99,599) that UnHappy Singh received (Rs 1,38,000). That is the magic of power of compounding as against simple interest. In fact, if you add a small amount of money each month to your initial investment and make this a recurring monthly investment, the results are mind boggling – you shall see that in the graphics below in a bit. For now, check the graph below to show the figures.

And if you want to see how the money is growing each year by simple versus compound interest, check below. FV = Future Value.

Let’s pause for some learning from Wiki.

Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets lent.

When money is borrowed, interest is typically paid to the lender as a percentage of the principal, the amount owed to the lender. The percentage of the principal that is paid as a fee over a certain period of time (typically one month or year) is called the interest rate. A bank deposit will earn interest because the bank is paying for the use of the deposited funds.

Interest is often compounded, which means that interest is earned on prior interest in addition to the principal.

Simple interest is called simple because it ignores the effects of compounding. The interest charge is always based on the original principal, so interest on interest is not included.

The concept of power of compounding arises when interest is added to the principal, so that, from that moment on, the interest that has been added to the principal also earns interest. This addition of interest to the principal is called compounding.

What is the big deal with the power of compounding ?

Since the power of compounding works best over a long period of time, finance pundits will tell you that you should start saving for your important goals like your retirement much early in your life. The time helps your small amount of money, the seed, to blossom into a huge corpus, the mango farm, from where you can draw your money, pluck mangoes, whenever you need to live your retirement life. This concept of starting to save early in your life should not be limited to just the goal of retirement but all your goals, mandatorily the major ones like education and marriage for your kids and retirement for you spouse and yourself.

My personal experience is that most investors make the educated move to save for their future by the time they are 35. Most are not aware of the personal finance milestones before they turn 30. Imagine what time you have lost in the process. What if you started investing when you got your first salary. But someone needs to drive home the point to you. That is where you need a mentor in the personal finance space.

Enjoy the infographics and share the word. Mangoes are always better enjoyed with the whole family.