Power of Compounding- How compounding makes your money big?

Power of Compounding
Power of Compounding
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The day I completed my graduation, my father called me to play chess with him. It was quite usual for me and I went in his room. Instead of playing chess he asked me to put a one rupees coin at the bottom corner box of the chess board.  I could not understand anything, but I put a rupee coin on that corner box. Then he said to double this amount and put two rupees in the second box, Four rupees in third box, Eight rupees in next to it and continue the same pattern till the last box of the chess board. I did the same. Within few boxes, my wallet became empty.

Then he suggested me to write the required amount on a piece of paper and put it on all the boxes of chess board in a sequence. When I reached on the 64th box which was last on the chess board, the amount written on the paper piece was in millions and  trillions.

I was looking at my father with surprise. He said to me very calmly, “Son, now you have become worthy that you can earn your own living. My aim behind this experiment was to show you that if you accumulate and invest the surplus funds at the right time, then due to compounding, small Investments also turn into huge amount of money. Started from one rupee, your money has become 512 rupees by reaching the tenth box and millions and trillions at the 64th box.

He explained me the power of compounding in few minutes.

What is compounding:

Compounding is the process to generate earnings on investments through getting interest on previous earnings. Compounding happens when interest is received repeatedly.

In this process, the interest is earned not only on the on principal amount but also on the previous interest on the principal amount invested.  This cycle leads to increasing interest, so the amount of money invested over time takes the form of a large corpus.

Difference between simple interest and Compound Interest

Simple interest can be defined as the interest earned only on the principal amount for a given period of time. It is calculated as per the below given formula –

Simple interest = P*R*N
P = Principal,
R = Rate in percent (5% means 5/100)
N = No of years

Compound interest is calculated on the revised principal after adding the previous interest. In this process the principal amountkeeps on increasing because the interest earned will also become a part of principal amount for further interest calculation. The basic formula to calculate the compound interest is –

C.I. = Principal (1 + Rate)Time – Principal

Now, see the difference in interest earned through simple interest and compound interest on the amount of Rs 1 lakh –

Compound InterestSimple  Interest (SI)Compound Interest (CI)
Principal Amount100000100000
Rate of Interest (yearly)0.120.12
No. of Years55
Total Value6000076235

There is a significant difference in amount earned as interest. Compounding is the key factor of this difference and it is due to its multiplier effect.

Power of compounding acts similarly in the mutual fund investments also. A smart investor can take maximum advantage of compounding by initiating an early investment in suitable mutual fund schemes for a longer duration.

Let the power of compounding show its magic to fund your dreams.It is relevant to mention the words of Albert Einstein on power of compounding “Compound interest is the eighth wonder of the world.”

Let’s prove this magic through an example of Mutual Fund SIP investment:

Two investors Shaurya and Tushar started investing in mutual fund scheme through SIP of Rs 25000 per month at the age of 20 and 30 respectively as per below given details

ParametersShauryaTushar
Age when started investing2030
Age on which scheduled to redeem6060
Total investment period in years10 years (upto age of 30)10 years (upto age of 40)
Investment holding period30 years20 years
Investment per month2500025000
Expected Rate of Return0.120.12
Total amount invested30000003000000
Accumulated amount at the time of redemption17.40 crore5.60 crore
Amount earned as interest17.10 crore5.30 crore

How it is calculated:
Shaurya invested Rs 25000 for 120 months. Then he stopped this investment. The amount accumulated at the end of 120 month was Rs 5808477 at the rate of 12% interest earning. He remained invested this amount for further 30 years till he attained the age of 60. The interest earned during this period was again 12% yearly. At the age of 60 he redeemed this investment. This investment of just 300000 rupees has converted into a corpus of Rs 17.40 crore.
Calculation of the second investor Tushar is also done on the same method.

This example clearly reflects the power of compounding and its proportionate relation with holding period of investment. How an investment of 25000 per month for a period of 10 years has converted in crores looks pretty miraculous but it happens in the real world. The magic of compounding increases in line with the holding period. 

What to do if I am in my Fifties:

It is always good to start investing early. Simultaneously it is also true that an investor can start investing in their fifties also. They still have many years during which they can compound their money by investing sensibly. The caution point is to avoid investing recklessly in the hope to make up lost time. Three basic things you need to do by yourself are:

  1. Invest carefully with suitable asset allocation.
  2. Create more investable surplus.
  3. Keep a track on your investments.

Rest all will be done by the power of compounding.

Example of Mutual Fund SIP investment at the age of 50:

Age when started investing in SIP50
Age on which scheduled to redeem60
Total investment period in years10 years (upto age of 60)
Investment per month50000
Expected Rate of Return0.1
Total amount invested6000000
Accumulated amount at the time of redemption1,03,27,601

This example clearly indicates that a corpus of more than 1 crore can be created by a person attained the age of 50 and having only 10 years to create a handsome corpus at the time of his retirement. He invested only 6000000 rupees that too in installments and earned a return of Rs Rs. 43,27,601. So, investors running in their fifties can also create a corpus of Rs 1 crore by investing a higher investable surplus sensibly.

The Crorepati Formula of Mutual Fund investments:

To become a Crorepati(millionaire) through mutual fund investment an investor needs to follow the well-known rule of investment i.e., the rule of   15 * 15 * 15. This rule can make an investor Crorepati by investing continuously for 15 years, a sum of Rs 15000 per month through SIP in an equity mutual fund having prospects to earn a return on investment @ 15%.

Parameters
Investment amount15000
Investment ModeSIP
Investment Period180 months (15 years)
Amount invested27 lakh
Expected rate of return0.15
Corpus generated after 15 years1,01,52,946

See the above table. This clearly reflects the worthiness of this well known rule of 15 thousand for 15 years at expected rate of return of 15%.

Although, it is difficult to predict the accurate rate of return in equity investment but historical trends of mutual fund equity investment for a longer duration gives many evidences when people earned even more than 15% return on their equity investments.

The Fun funda:

“In How much time, the money I am investing today will become double.” It is a common question of many investors.

A simple rule of thumb to estimate the time taken to double the investment, assuming a fixed annual rate of return is called Rule of 72 and similarly Rule of115 to find the time taken to triple the investment.

Rule of 72

Suppose an investor invested in a debt mutual fund scheme and expected average return is 8% per year, the time taken to get the money double will be 72 divided by 8 is equal to 9 years. If you assume the rate to be 9% instead, then the time taken will to double the investment will become 8 years.

Similarly, if you want to estimate the time taken in get your investment triple at an expected average return of 5% per year, it will be 115 divided by 5 is equal to 21 years. But if the assumed rate of return is 10%, then the time taken to triple the investment will become 11.5 years.

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