POWER OF COMPOUNDING
Sachin Tendulkar started playing cricket at the age of 16. At 29, he has already amassed over 12,000 runs in one-day matches. On the other hand, Robin Singh joined the Indian team at the age of 25 and he could manage only 2,336 runs in one-day matches. The idea is simple: the earlier you start investing, the more likely it is that you would end up making more money. While runs scored in cricket do not multiply automatically, investment does. Surprised? Well, the fundamental principle of compounding helps you realize this.
Let us see how the concept of compounding works. Suppose Sachin started investing Rs 1 Lakhs per year at the age of 19 and when he reaches 30, he stops investing and locks all his investments till retirement. Robin, however, does not make any investment till he is 27. At 27, he starts investing Rs 1 lakhs a year till the age of 60. The adjacent table tells you how their investments would turn out when they both are 60, assuming that the growth rate is 15 per cent per annum. The results are eye-popping (see Compounding: A Tale of Two Investors.
|
Sachin |
Robin |
||||
|
AGE |
Annual Investment |
Year-end valuations @ 15% per year (In Lakhs) |
AGE |
Annual Investment |
Year-end valuations @ 15% per year (In Lakhs) |
|
19 |
1.00 |
1.15 |
27 |
1.00 |
1.15 |
|
20 |
1.00 |
2.47 |
28 |
1.00 |
2.47 |
|
21 |
1.00 |
3.99 |
29 |
1.00 |
3.99 |
|
22 |
1.00 |
5.74 |
30 |
1.00 |
5.74 |
|
23 |
1.00 |
7.75 |
31 |
1.00 |
7.75 |
|
24 |
1.00 |
10.07 |
32 |
1.00 |
10.07 |
|
25 |
1.00 |
12.73 |
33 |
1.00 |
12.73 |
|
26 |
1.00 |
15.79 |
34 |
1.00 |
15.79 |
|
27 |
1.00 |
19.30 |
35 |
1.00 |
19.30 |
|
28 |
1.00 |
23.35 |
36 |
1.00 |
23.35 |
|
29 |
1.00 |
28.00 |
37 |
1.00 |
28.00 |
|
30 |
1.00 |
33.35 |
38 |
1.00 |
33.35 |
|
31 |
0.00 |
38.35 |
39 |
1.00 |
39.50 |
|
32 |
0.00 |
44.11 |
40 |
1.00 |
46.58 |
|
33 |
0.00 |
50.72 |
41 |
1.00 |
54.72 |
|
34 |
0.00 |
58.33 |
42 |
1.00 |
64.08 |
|
35 |
0.00 |
67.08 |
43 |
1.00 |
74.84 |
|
36 |
0.00 |
77.15 |
44 |
1.00 |
87.21 |
|
37 |
0.00 |
88.72 |
45 |
1.00 |
101.44 |
|
38 |
0.00 |
102.02 |
46 |
1.00 |
117.81 |
|
39 |
0.00 |
117.33 |
47 |
1.00 |
136.63 |
|
40 |
0.00 |
134.93 |
48 |
1.00 |
158.28 |
|
41 |
0.00 |
155.17 |
49 |
1.00 |
183.17 |
|
42 |
0.00 |
178.44 |
50 |
1.00 |
211.79 |
|
43 |
0.00 |
205.21 |
51 |
1.00 |
244.71 |
|
44 |
0.00 |
235.99 |
52 |
1.00 |
282.57 |
|
45 |
0.00 |
271.39 |
53 |
1.00 |
326.10 |
|
46 |
0.00 |
312.09 |
54 |
1.00 |
376.17 |
|
47 |
0.00 |
358.91 |
55 |
1.00 |
433.75 |
|
48 |
0.00 |
412.75 |
56 |
1.00 |
499.96 |
|
49 |
0.00 |
474.66 |
57 |
1.00 |
576.10 |
|
50 |
0.00 |
545.86 |
58 |
1.00 |
663.67 |
|
51 |
0.00 |
627.73 |
59 |
1.00 |
764.37 |
|
52 |
0.00 |
721.89 |
60 |
1.00 |
880.17 |
|
53 |
0.00 |
830.18 |
|||
|
54 |
0.00 |
954.70 |
|||
|
55 |
0.00 |
1,097.91 |
|||
|
56 |
0.00 |
1,262.60 |
|||
|
57 |
0.00 |
1,451.99 |
|||
|
58 |
0.00 |
1,669.78 |
|||
|
59 |
0.00 |
1,920.25 |
|||
|
60 |
0.00 |
2,208.29 |
|||
|
Total |
12.00 |
2,208.29 |
34.00 |
880.17 |
|
|
Lakhs |
Lakhs |
Lakhs |
Lakhs |
||
Compounding is a simple, but a very powerful concept. Why powerful? Because compounding is similar to a multiplier effect since the interest that is earned by the initial capital also earns an interest, the value of the investment grows at a geometric (always increasing) rate rather than an arithmetic (straight-line) rate (see How Compounding Works). The higher rate of return, the steeper curve.
Basically, compounding is a long-term investment strategy. For example, when you own a mutual fund, compounding allows you to earn interest on your principal. Compounding also occurs when you re-invest your earnings. In the case of mutual funds, this means re-investing your interest or dividend, and receiving additional units. By doing such a thing, you are earning a return on your returns and the principal. When the principal is combined with the re-invested income, your investment will grow at an increased rate.
The best way to take advantage of compounding is to start saving and investing wisely as early as possible. The earlier you start investing, the greater will be the power of compounding.
