The Power of Compounding
Before we begin to understand the ‘Power of compounding’ the first question that pops is, ‘What is compounding?’. Benjamin Franklin defines compounding in simple words “Money makes money. And the money that money makes, makes money.”
Imagine a snowball at the top of a cliff. When it starts rolling down, it picks up more snow along the way. Over time, the rolling mass becomes humongous. That is how compounding works.
Now, instead of snow, imagine your money growing like that ball of snow over the years. Incremental gains over multiple years lead to significant results. Such is the Power of Compounding.
Warren Buffet, whose autobiography is interestingly called ‘The Snowball’, has been the flag-bearer of compound interest all his life. He says compounding is one of the SAFEST ways to make money over time.
Compound interest is better than simple interest when it comes to investing. The graph shows the difference between the amounts calculated using both simple interest and compound interest. Through compounding, investments grow at a much faster pace. The pace increases as the time period increases.
Now that we have answered the first question, the second question that pops up is ‘How does the compounding process work?’.
Let us try to understand this through an example.
There are two friends Manish and Ramesh.
Manish is 30 years old while Ramesh is 25. Both of them decide to invest money till they turn 40. Manish invests Rs 100 at a 10% interest rate for 10 years.
After the first year, the interest earned on the initial amount will be Rs 10. The new base will become Rs 110(100+10) for the next year. Now, 110 will be used to calculate interest in the second year instead of Rs 100. The interest will be Rs 11. And in this way, the same exercise will be applied in the coming years.
The compounding process will multiply Manish’s wealth by 1.6 times.
On the other hand, Ramesh’s wealth will multiply by 3.1 times. This is because he invested money for an extra 5 years.
Time is thus the most critical factor in the compounding process
Say a third person decides to invest the same amount for 30 years. The power of compounding will show its magic and multiply his income by 16.4 times.
In the world of investing, it’s best to start as early as possible. Intelligent investors have used the power of compounding to build generational wealth. Instead of focusing on earning more money, the power of compounding focuses on growing your money. Having one crore plus corpus for yourself seems like a far-fetched idea, but the power of compounding can make it a reality.