Power of Compounding – How is it used in Investing?

The Power of Compounding is one of my favorite topics – because

it is very SIMPLE to understand,

is a very POWERFUL concept and

it is for EVERYONE.

Power of Compounding is nothing but the value that one can create from 1 single investment over a long period of time.   It also defines the value of a certain amount of money invested today, versus being invested later, i.e. the time value of money.

To explain this we have to take some simple examples.

The Power of TIME

Let us assume that Ravi is 25 years old and this year he gets a bonus of Rs. 1,00,000 which he decides to invest.  Let us also assume that he gets a consistent 6% interest on this amount.  So after 1 year, his amount grows by Rs. 6,000 to Rs. 1,06,000. By the end of the second year, it has grown by 6% (of Rs. 1,06,000), i.e. by Rs. 6,360 to Rs. 1,12,360.

When the third year ends, it has grown further by Rs. 6,742 to Rs. 1,19,102.

At the end of the fourth year, another Rs. 7,146 gets added as interest – the value of his money is now Rs. 1,26,248.

As time passes, the amount has grown to Rs. 1,33,823 by end of fifth year and to Rs. 1,41,852 by the end of the sixth year.  Now look at the table below.   (Click anywhere on the table to see it full screen)

By the time Ravi retires, i.e. at the age of 60, i.e. after 36 years, the Rs. 1 lakh that Ravi had invested has grown more than 8 times to a whopping Rs. 8.14 lakhs!  In the last 2-3 years, the value is increasing by more than Rs. 40,000 in each year!  THAT is the power of compounding. 

But it does not end here.

The Power of INTEREST RATE

Interest rate is a crucial factor in the Power of Compounding.

Now let us assume that instead of 6% interest rate, Ravi gets double the rate – i.e. 12%.  So what do you think will be the value of the same Rs. 1 lakh that Ravi had invested?  Double? i.e. Rs. 16.28 lakhs?  Hold your breath – you may be shocked to see this.  Look at the table below.  (Click anywhere on the table to see it full screen)

The Rs. 1 lakh that Ravi has invested has grown at the rate of 12% each year to (!) Rs. 59.13 lakhs!!!  That’s correct. And you will notice that in the last 2-3 years, the amount grew by more than Rs. 5 lakhs each year!  Amazing, isn’t it?  That’s again the Power of Compounding.  And it is just simple arithmetic.

Reaching a FINANCIAL GOAL

By now you would have understood the impact of Power of Compounding.  But how do you use it to achieve your financial goals?

Using the 12% example, assume that Ravi had a financial goal in mind.  Say, he wanted to create a retirement fund of Rs. 50 lakhs after 36 years when he turns 60, to support him and his wife after retirement.  To create this fund at a rate of interest of, say 10%, he has to invest Rs. 1,61,746 at the age of 25.

But he could not do so because of other financial priorities and instead invested only from age 42 for half the time i.e. for 18 years till he turned 60.  Now his requirement is still the same – i.e. Rs. 50 lakhs is required at the age of 60.  Since he started half-way, is it enough to invest, say, double the amount to get to the goal of Rs. 50 lakhs by age 60?

Let’s see how the story unfolds.  See the table below.  (Click anywhere on the table to see it full screen)

To get to the same goal and the same rate of interest of 10%, if Ravi starts at 42 years, he has to invest Rs. 8,17,540, i.e. more than 5 times the amount that he would have invested if he had done so at age 25!  The Power of Compounding is amazing, isn’t it?

Using Power of Compounding in Investing

There is no point only understanding the Power of Compounding unless we use it for investing. So here’s a summary.

For investors, the learning is summarized below.

So if your Fixed Deposit is giving you 6% and a Debt Mutual Fund is giving you 8%, don’t think it is just 2% extra.  The end value of the investment at 8% could be more than double the value at 6%.

 Now remember that all this you have read is the power of compounding for just one investment that you make.  Can you imagine the value of a series of such small regular investments made over time?   Try it for yourself and make sure you use it for your investing discipline.