The Power of Compounding

  • Aaditya Sridharan

It is said that it is wise to listen to what great people have to say, because it’s usually something that is worth thinking about. Albert Einstein had once said, “Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it.”

It would be wise for us to think about what he said. So let’s do that. Let us start by understanding what compound interest actually is. We will then study a real life example to truly understand the power of compounding.

In the simplest of explanations, compound interest is when you earn interest ON the interest you earn by investing the principal amount. This leads your money to grow at an ever accelerating rate, as the interest earned keeps increasing, and the interest on the interest earned becomes larger.

Suppose you are earning interest of 10% on an investment of Rs. 50,000/-, and the term of the investment is 3 years. When the interest is calculated on the basis of simple interest, then over the three years, the interest earned will be 15,000 Rupees (10% of 50,000/- which is 5,000/- a year). When the interest is calculated on the basis of compound interest, then the interest earned over the three years will be 16,550 Rupees. If the interest is to be compounded, in the second year, the interest will be calculated as 10% of 55,000/- (50,000/- Principal + 5,000/- interest earned in first year). Similarly, in the third year, the interest will be calculated as 10% of 60,500/- (50,000/- Principal + 5,000/- interest earned in first year + 5,500/- interest earned in second year).

Now that we have understood the basic concept of compound interest, let us have a look at the power it exhibits when the term of investment is long. Let us consider the hypothetical situation of three friends, Raj, Rita and Rahul.

Raj is an investor who did not start investing till he was 35. From 35 to 60, he invests Rs 5,000/- every month in his portfolio. Rita started investing when she was young, but did not continue it after a while. She invests the same amount as Raj, i.e. Rs 5,000/- a month, but from age 25 to 35 only. Rahul on the other hand plays the role of an ideal investor and invests Rs. 5,000/- a month continuously from age 25 to 60. Let us know look at the corpuses that each of them will end up with at their time of retirement. We will consider, for purposes of simplicity, that each of the three friends earn a fixed rate of 9% interest per annum on their investments.

1) Raj, at the end of 60 years, would have invested a total of Rs. 15,00,000/- in his portfolio, but the returns it would generate would be Rs. 55,39,439/-. The interest earned will be Rs. 40,39,439/-.

2) Rita, at the end of 35, would have invested Rs. 6,00,000/- in her portfolio, but the value of her investments would be Rs. 9,93,618/-. If this amount is then kept to grow till Rita is 60, with no further payments, the corpus generated at the end would be worth Rs. 85,68,048/-.

3) Rahul, our ideal investor, at 60, would have invested a total of Rs. 21,00,000/- in his portfolio. However, the value of his portfolio would be a staggering Rs. 1,41,07,483/-. He would have earned an interest of Rs. 1,20,07,483/-

It is amazing to see that Rita, by just starting a few years earlier, is able to earn far more interest on her money than Raj, even though Raj invests 2.5 times more than Rita. This truly remarkable feat is only achieved as a result of Compound Interest.

Though not the point of the exercise, we can also see that our ideal investor, Rahul, is the best off amongst all the three, as he started early, and maintained the discipline of investing throughout his life.

Aaditya Sridharan

Aaditya Sridharan is an engineer by degree, but an analyst by heart. He is incredibly fascinated by the markets and the potential they hold for any intelligent investor. He hopes to help people realize the true potential of their wealth and change the norm of keeping the savings in a bank account that is prevalent in the country.