The Power of Compounding

There is an Internet story going around about a poet who, due to hard times, was no longer able to feed his family. A King, pleased by his recitation, asked him to name his reward. The poet, pointing to the chessboard said, “If you place just one grain of rice on the first square of this chess board, and double it for every square, I will consider myself well rewarded.” King was surprised by this and asked the poet to reconsider his reward. However, poet was satisfied with this reward.

King ordered his courtiers to start placing the grain on the chess board. One grain on the first square, 2 on the second, 4 on the third, 8 on the fourth and so on. The number swelled to 524,288 grains on the 20th square. When they came to the half way mark, the 32nd square, the grain count was 2,147,483,648 i.e. more than 2 billion and soon the count increased to lakhs of crores. Eventually the hapless King had to hand over his entire kingdom to the clever poet.

The story ends with the moral - “Never underestimate the power of compounding. If you stay invested long enough, it’ll work for you. A small sum invested every month from the beginning of your work-life can lead to a very impressive amount at the time of your retirement.”

The power of compounding can work magic to your wealth. It, along with the benefit of time, can multiply your investment.

Let us consider a hypothetical example of Anil and Sunil. Anil started investing Rs. 5,000 per month from the age of 25 years, whereas Sunil was a spendthrift in his early life and started investing at the age of 45 years. He thought by investing more (Rs. 11,667) till the time of his retirement, he will manage to invest the same amount as Anil till retirement. We assume both earn the same amount on their investment, @ 10% p.a. Let us have a look at how their investment grows.

	Anil	Sunil
Investment Start Age (in year)	25	45
Investment amount p.m. (in Rs.)	5,000	11,667
Retirement Age	60 years	60 years
Profit / Interest rate	10%	10%
Total Principal Investment (in Rs.)	21,00,000	21,00,000
Wealth at the age of 60 (in Rs.)	1,89,83,190	48,35,626

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The difference is startling. Anil’s wealth at the age of 60 years is Rs. 1.90 crores whereas Sunil’s wealth is just Rs. 48 lakhs even though both have invested the same principal of Rs. 21 lakhs till their retirement. Anil’s wealth is little less than 4 times the wealth of Sunil.

The above illustration shows the benefit of compounding and investing early. Ideally one should start investment the moment the first salary cheque is received and should continue it periodically.

To benefit from compounding, start saving right now. Determine the amount of monthly savings required to achieve your lifestyle goals and allocate it to different asset class as per your investment and risk profile. Start investing the monthly savings to these assets class by way of standing instructions to Bank and by authorising your Financial Advisor.

Do not know how to determine your investment and risk profile and the amount of monthly savings required to achieve your lifestyle goals?  Don't worry.  Bachhat will cover all this and much more in subsequent posts.  

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