There is this story about the man who invented chess may years ago. It is said that the king of the land was so impressed that he summoned the inventor and asked him to take a gift from him. The inventor thought for a while and said that he wanted 1 grain of wheat for the first square, 2 grains for the 2nd square and 4 grains for the 3rd square, and 8 for the 4th square and so on – doubling the number of grains every square till he reached 64 squares. The king was offended at what he thought was a very small request and he ordered his staff to attend to it. Many hours later he was surprised to learn that his staff was still calculating. After many more hours he was told that the demand was such that whole planet would not be able to fulfill.
The monstrous number of grains required was 18,446,744,073,709,600,000 !!! That amounts to trillions of tons of wheat, which is more than what the world has produced in the history of the planet.
That is the magic of compounding. What looked like an innocuous 31 grains after 5 squares had built up to this monster figure by the time the 64th square was reached. The secret to making money also lies in using the power of compounding effectively.
Albert Einstein is supposed to have said that the most powerful force in the universe is compound interest. And it's true. Compound interest describes how investments can snowball over time. Just as a snowball gets bigger and bigger and rolls faster and faster as it tumbles down a mountain, the same can be true with your investments. Due to the power of compounding, the value of your portfolio can grow faster each year because you earn interest not only on what you invested, but also on the interest you earn. The money you make will depend on three factors:
How much money you invest
How much time it spends growing
Its rate of growth
To illustrate the above points, let’s look at a few examples. We look at three investment alternatives – Rs 10,000 per month, Rs 15,000 per month and Rs 20,000 per month. In terms of returns, we will look at three examples – 10% pa, 15% pa and 20% pa. In terms of time frame, we will look at 10 years.
What will be the final value of the investments? For starters, the simplest thing to calculate is the amount invested in each case, which will be Rs 12 lakh, 18 lakh and 24 lakh respectively. What will they amount to after 10 years? Take a look below –
· 10,000 per month at 10% pa return will amount to 20 lakh. At 15% pa it will amount to 26 lakh and at 20% pa it will amount to 34 lakh.
· 15,000 per month at 10% pa return will amount to 30 lakh. At 15% pa it will amount to 39 lakh and at 20% pa it will amount to 51 lakh.
· 20,000 per month at 10% pa return will amount to 40 lakh. At 15% pa it will amount to 52 lakh and at 20% pa it will amount to 68 lakh.
You would notice at once that the returns do not vary linearly. The difference between amount invested and returns for the best case (20,000 at 20% and 10,000 at 10%) is a huge 36 lakh. When you look at the other dimension time (just compute the above figures for 15, 20 and 25 year time horizons) the differences will compound even more.
Remember that not all growth rates are the same. If your bank is paying 6-8% interest on your savings, that's safe and guaranteed money. The stock market, however, is not a sure thing. Stock market returns fluctuate. There are good years, great years, and terrible years. Over long periods of time, though, the stock market tends to go up. Over many decades, in India, it has averaged an annual 20% return.
In general, the more certain the growth rate, the lower it will be. The more risky it is, the higher it will be.
The lesson here is that discipline in terms of amounts invested and the time invested s to be combined with risk in terms of returns to get great overall long term results. Risk alone will not do much and discipline alone will take you some way but not too far.
