The Power of Compounding
The best time to plant a tree was 20 years ago. The second best time is now.
Chinese Proverb
As an adviser and mentor to many people, I am often asked to say in simple terms how to create great wealth. There is no secret formula involved here. It is no rocket science and is one of the easiest things to understand and learn. However, it is strange that not many do it. The formula is: start early. Start investing your money at the earliest; let the magic of compound interest create a sizeable wealth for you.
Though the price of real estate has come down considerably in recent times, for most Indians, buying a house remains a difficult financial decision. It may mean committing a substantial part of your future earnings also, especially if you are considering buying a property in one of the metro cities. Children’s education is an expensive affair these days, and depending on the stream chosen, it may leave you poorer by ₹50 lakhs or even more. Marriages continue to be expensive affairs in India, and people usually end up spending way beyond the justifiable limits. Add to this the contingencies, the medical emergencies, the lifestyle-related expenditure (tours abroad, phones, cars), and it looks like a big gap between saving and the required amount.
While it is a daunting task, it is achievable. Invest early—the earlier, the better—so that the multiplier of compound interest can multiply your capital many times over. Once it gets going, the magic is unstoppable: ₹1 becomes ₹2, ₹2 becomes ₹4, ₹4 become ₹8 . . . And soon your money grows at an astonishing rate of growth even when invested in securities that grow at a low annual rate of growth.
A young professional who has just started his career will find low investible surplus, and he would think it is better to spend that small sum instead of investing it, as small savings might not contribute much to his long-term corpus requirement. This is the biggest mistake he could make. Sow the seed early, water it regularly, and I assure you, the crop you reap will be stupendous. It will be higher than the return of his friend who starts later even if the latter invests more money.
Most people procrastinate. Some are inspired by the ‘eat, drink, and be merry’ philosophy, while many others remain ignorant. People don’t know what they could have done with their money. They don’t realise their investment options until it is too late and until it spirals into a crisis. A typical procrastinator may be seen discussing the macroeconomic situation which is ‘grim’, ‘recessionary’, ‘bleak’, or ‘terrible’ and is waiting for the situation to improve so he can invest. If he is not concerned about the macro-parameters, he is not able to decide on which stock to invest in. He sits on cash which earns zero return in absolute terms (and negative return when inflation is considered) or burns cash since there is no worthwhile investment vehicle available.
Investing early has interesting consequences for you. You may retire early while your colleagues are still struggling to make ends meet. Even if you reduce the contribution at a later stage of your life, it may not make a significant difference to your corpus, which will have grown to an impressive figure by then. Your twenty-year-old tree will have developed enough roots and branches to stand on its own by then.
Some readers may realise their folly but will have already lost precious time. The lost time cannot be regained. What then is the optimum solution for you? To make up for the lost time, you will now need to invest a larger quantum. You may have to curtail certain expenditures or increase your sources of income to match up the pace of the tortoise that started slow and steady twenty or thirty years back and is now way ahead of you in the race.
Einstein is said to have called compound interest the eighth wonder of the world and said, ‘Those who understand it earn it, and those who don’t pay it.’ For the magic of compound interest to work, the baseline needs to reach a certain scale. Compounding is parabolic. The longer the time you give for the base to build, the higher it will take you. Few people have enough patience or foresight to realise this. If you want the magic of compound interest to work for you, you must start at the earliest and build the base early so that the ball gets rolling on its own. If you have understood the importance of compounding in the early stage of your career, nothing can stop you from becoming rich. Even a modest income, if invested and stays invested for a long period, can make you wealthy beyond imagination.
Warren Buffett gives the example of the Mona Lisa to explain the power of compounding. King Francis I of France had asked Leonardo da Vinci to paint the Mona Lisa at a cost of $20,000. It holds the Guinness world record for the highest known insurance valuation in history at $100 million in 1962. This figure looks astounding until you consider that if $20,000 had been invested at 6% per annum, it would have grown to $1 quadrillion by 1962; that’s 3,000 times the national debt. He says, ‘If Francis had kept his feet on the ground and he (and his trustees) had been able to find a 6% after-tax investment, the estate now would be worth something over $1,000,000,000,000,000. That’s $1 quadrillion or over 3,000 times the present national debt, all from 6%. I trust this will end all discussion in our household about any purchase or paintings qualifying as an investment. However, as I pointed out last year, there are other morals to be drawn here. One is the wisdom of living a long time. The other impressive factor is the swing produced by relatively small changes in the rate of compound.’
In 1987 when I started my practice, I had purchased two computers with MS-DOS operating system from Wipro for ₹45,000. (For those who are curious to know, one of them had two floppy drives and no hard disk. You put the operating system floppy in drive A, and the data and application floppy in drive B. The other one had a floppy drive and, thankfully, a 10 MB hard disk. The computers had a 128 KB RAM.) If instead of buying the computers, I had bought Wipro shares for ₹45,000, they would have been worth more than ₹400 crores now, after considering the bonus, splits, dividends, and price rise! That is the loss of profit!
(Dr Tejinder Singh Rawal is the author of the bestselling book Loads of Money: Guide to Intelligent Stock Market Investing: Common Sense Strategies for Wealth Creation)
Chinese Proverb
As an adviser and mentor to many people, I am often asked to say in simple terms how to create great wealth. There is no secret formula involved here. It is no rocket science and is one of the easiest things to understand and learn. However, it is strange that not many do it. The formula is: start early. Start investing your money at the earliest; let the magic of compound interest create a sizeable wealth for you.
Though the price of real estate has come down considerably in recent times, for most Indians, buying a house remains a difficult financial decision. It may mean committing a substantial part of your future earnings also, especially if you are considering buying a property in one of the metro cities. Children’s education is an expensive affair these days, and depending on the stream chosen, it may leave you poorer by ₹50 lakhs or even more. Marriages continue to be expensive affairs in India, and people usually end up spending way beyond the justifiable limits. Add to this the contingencies, the medical emergencies, the lifestyle-related expenditure (tours abroad, phones, cars), and it looks like a big gap between saving and the required amount.
While it is a daunting task, it is achievable. Invest early—the earlier, the better—so that the multiplier of compound interest can multiply your capital many times over. Once it gets going, the magic is unstoppable: ₹1 becomes ₹2, ₹2 becomes ₹4, ₹4 become ₹8 . . . And soon your money grows at an astonishing rate of growth even when invested in securities that grow at a low annual rate of growth.
A young professional who has just started his career will find low investible surplus, and he would think it is better to spend that small sum instead of investing it, as small savings might not contribute much to his long-term corpus requirement. This is the biggest mistake he could make. Sow the seed early, water it regularly, and I assure you, the crop you reap will be stupendous. It will be higher than the return of his friend who starts later even if the latter invests more money.
Most people procrastinate. Some are inspired by the ‘eat, drink, and be merry’ philosophy, while many others remain ignorant. People don’t know what they could have done with their money. They don’t realise their investment options until it is too late and until it spirals into a crisis. A typical procrastinator may be seen discussing the macroeconomic situation which is ‘grim’, ‘recessionary’, ‘bleak’, or ‘terrible’ and is waiting for the situation to improve so he can invest. If he is not concerned about the macro-parameters, he is not able to decide on which stock to invest in. He sits on cash which earns zero return in absolute terms (and negative return when inflation is considered) or burns cash since there is no worthwhile investment vehicle available.
Investing early has interesting consequences for you. You may retire early while your colleagues are still struggling to make ends meet. Even if you reduce the contribution at a later stage of your life, it may not make a significant difference to your corpus, which will have grown to an impressive figure by then. Your twenty-year-old tree will have developed enough roots and branches to stand on its own by then.
Some readers may realise their folly but will have already lost precious time. The lost time cannot be regained. What then is the optimum solution for you? To make up for the lost time, you will now need to invest a larger quantum. You may have to curtail certain expenditures or increase your sources of income to match up the pace of the tortoise that started slow and steady twenty or thirty years back and is now way ahead of you in the race.
Einstein is said to have called compound interest the eighth wonder of the world and said, ‘Those who understand it earn it, and those who don’t pay it.’ For the magic of compound interest to work, the baseline needs to reach a certain scale. Compounding is parabolic. The longer the time you give for the base to build, the higher it will take you. Few people have enough patience or foresight to realise this. If you want the magic of compound interest to work for you, you must start at the earliest and build the base early so that the ball gets rolling on its own. If you have understood the importance of compounding in the early stage of your career, nothing can stop you from becoming rich. Even a modest income, if invested and stays invested for a long period, can make you wealthy beyond imagination.
Warren Buffett gives the example of the Mona Lisa to explain the power of compounding. King Francis I of France had asked Leonardo da Vinci to paint the Mona Lisa at a cost of $20,000. It holds the Guinness world record for the highest known insurance valuation in history at $100 million in 1962. This figure looks astounding until you consider that if $20,000 had been invested at 6% per annum, it would have grown to $1 quadrillion by 1962; that’s 3,000 times the national debt. He says, ‘If Francis had kept his feet on the ground and he (and his trustees) had been able to find a 6% after-tax investment, the estate now would be worth something over $1,000,000,000,000,000. That’s $1 quadrillion or over 3,000 times the present national debt, all from 6%. I trust this will end all discussion in our household about any purchase or paintings qualifying as an investment. However, as I pointed out last year, there are other morals to be drawn here. One is the wisdom of living a long time. The other impressive factor is the swing produced by relatively small changes in the rate of compound.’
In 1987 when I started my practice, I had purchased two computers with MS-DOS operating system from Wipro for ₹45,000. (For those who are curious to know, one of them had two floppy drives and no hard disk. You put the operating system floppy in drive A, and the data and application floppy in drive B. The other one had a floppy drive and, thankfully, a 10 MB hard disk. The computers had a 128 KB RAM.) If instead of buying the computers, I had bought Wipro shares for ₹45,000, they would have been worth more than ₹400 crores now, after considering the bonus, splits, dividends, and price rise! That is the loss of profit!
(Dr Tejinder Singh Rawal is the author of the bestselling book Loads of Money: Guide to Intelligent Stock Market Investing: Common Sense Strategies for Wealth Creation)
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