Compounding is a powerful tool that allows you to turn small savings into substantial wealth over time. The concept of compounding is simple: when you invest money, you earn returns on that investment. Then, the returns you earn also earn returns, and so on. So the base on which returns are calculated, increases every time you earn returns. Over time, this process can create a snowball effect, allowing your investments to grow exponentially.
One of the most famous stories about compounding is that of the chessboard and the grains of rice. According to the story, a king asked a wise man to come up with a reward for his services. The wise man asked for a chessboard with one grain of rice on the first square, two on the second, four on the third, and so on, doubling the number of grains of rice on each subsequent square. The king agreed, not realising the implications of exponential growth. By the time the last square was reached, the amount of rice required was more than 18 quintillion grains, far more than the entire world’s rice production.
The king is not unique. As humans, our brains find it difficult to deal with compounding calculations. Let’s take another example. Suppose you invest Rs 1,000 each month earning 10% pa for 20 years. At the end of 20 years, you would have invested Rs 2,40,000 but your money has grown 3 times to Rs 7,23,987.
Now suppose you increase your monthly investment of Rs 1,000 by 10% per annum. So in year 2, you would invest Rs 1,100 each month, in year 3 Rs 1,210 each month and so on. At the end of 20 years, you would have Rs 15,46,167. This is more than double the value without the increased investment every year.
Now suppose, instead of 20 years, you invest for 25 years. Instead of Rs 15,46,167, you would have Rs 31,12,648. The amount of your money more than doubled in just 5 years.
Hence, if you withdraw your investments too early, you miss out on the magic that compounding does in the later years. Take a look at the chart below, based on the earlier examples.
For half of the 25 years, you can barely see the growth, but look what happens after that. There’s a dramatic rise.
Now let’s see how the NIFTY 50 Index of shares performed for over 20 years.
As you can see, while the trend is upwards, it is not a smooth curve upwards. There are ups and downs. Therefore we say that the main skill in investing is patience. Don’t panic during the downs or get excited with the ups or fiddle too much with your investments. Be patient and let compounding do its magic.
By investing consistently and letting your returns compound, you can turn small savings into substantial wealth. The earlier you start, the more consistently you invest and the longer you let your investments compound, the greater the potential for wealth creation. This can mean the difference between a comfortable retirement and one that’s financially stressful.