Saturday, 18 August 2018

Compound Interest: The Eighth Wonder

Yeah, that’s what Einstein said about compound interest

“Compound interest is the eighth wonder of the world, he who understand it, earns it…he who doesn’t…pays it.”

In this article, am going to explain you how compounding affects our investments and how powerful actually it is.

Do you remember high school mathematics classes, while the formula of simple interest was quite simple, it was compound interest which came up with so many variables. The logic behind compound interest is pretty simple, here the earnings are reinvested, as per the frequency of compounding, at the same rate of return to constantly grow the principal amount. Compounding is a powerful tool in the investment world as it makes your money work harder for you. Let’s understand the power of compounding with three small cases.

Case I:
Lucky starts his first job, at the age of 25, with a monthly salary of Rs. 30,000. While he was watching a video on youtube, the SIP ad popped up. The next day, he gathered some more information about SIP from his colleagues and gets convinced to invest Rs. 5,000 per month. His colleagues had suggested to start as early as possible and to take the SIP route with a long term view to see the real power of compounding. While he was still wondering about the significance of time and age in investing, his friend came with following calculations:

Investment per month
Rs. 5,000
Expected rate of return
15% p.a
Value of Investment after 10 years
Rs. 1,393,286 (approx. 14 lakh)
Of which:
Principal Amount: 6 Lakh
Interest earned: 8 lakh (approx.)
He further explains, “if you stay invested for 5 more years, the scenario would be”
Value of Investment after 15 years
Rs. 3,384,315 (approx. 34 lakh)
 Of which:
Principal Amount: 9 Lakh
Interest earned: 25 lakh (approx.)
Yup, that’s more than double!

Case II

“Yeah, I can see the importance of being invested for long, but how does age matter?” asked Lucky.
His friend then tells him about another colleague, Unlucky. Unlucky started his career at the same age but realized the importance of investing at the age of 35. Lucky’s friend again came up with the calculations:
Present age: 25
Time left before retirement: 35 years
Present age: 35
Time left before retirement: 25 years
Assuming that they both invest Rs. 5,000 per month till they retire and get an average return of 15% p.a. on their investment, amount accumulated at the end of investment period would be:
Lucky: Rs. 74,303,225
Unlucky: Rs. 16,420,369

You can clearly see the difference.

Case III
“But his salary is triple than that of me, he can invest much more than me”, said Lucky.
His friend had a solution for this too.
Let’s assume that Unlucky starts investing Rs. 15,000 per month instead of Rs. 5,000. He invests the same amount each month till his retirement, that is, for next 25 years. Expected rate of return remains same, 15% p.a.
Can you guess the amount Unlucky will get after 25 years?
 It’s Rs. 49,261,106 (approx. Rs. 5 crores)
It’s still less than Rs. 74,303,225 (approx. Rs. 7.4 crores) of Lucky.
Conclusion: even if Unlucky invests 3X more than Lucky, he will have to pay the cost of starting late.

And that’s the magic of compounding.

Moral of the story:
-          Start investing as early as possible
-          Stay invested for long (do not bother about short term volatilities in the market)