What are the most powerful forces of the world? When someone asks us this question, few of the universal powers like Gravity, Sun, Black Hole etc. come to our mind. The Power of compounding is also one of the most powerful forces in the world.
Albert Einstein said Power of compounding as the 8th wonder of the world. He who understands it, earns it. He who doesn't, pays it.”
In school days, I used to wonder what it was? It was just about investment and savings. How can it be the 8 th wonder? Many of us must be having similar questions. When you understand this power, you will know how effective it is. Many people have become successful because they understood this concept in earlier years of their life.
Warren Buffet, one of the greatest investors of all time has said compounding as one of the reasons for his becoming wealthy.
Lets understand the power of compounding with the help of a simple example.
Mr. John went for an interview in a company. The HR gave him two options for his monthly take home pay.
Option A - Get a fixed salary of $ 5000/- per month for the next 30 months .
Option B – Get $0.01 as salary in the first month. Then in each subsequent month the salary grows twice of the salary taken in the last month. Meaning his salary would be $0.01 in the first month, $0.02 in the second month, $0.04 in the third month and so on.
Take a minute to think the option that will give you the maximum pay.
At the end of 30 months, John would get $150,000 in Option A.
In Option B, he would get a total salary of $ 10.7 million. Yes, you got it right. The total pay in Option B would be $10.7 million in 30 months.
This is because of the magic of power of compounding. In this option, his salary doubles every month. For the first few months his salary is much less compared to option A. His salary becomes almost equivalent to option A in the 20th month. After that because of compounding his salary keeps on increasing every month.
Out of the $10.7 million, $ 5.4 million (more than half of the total amount) is earned in the 30 th month. The impact of compounding is less in earlier period and magnifies significantly in later period. Since it is slow in earlier period it is not easy for people to realize its impact. This is the main reason why people are not able to hold their good investment for long period of time.
Charlie Munger said, “ Understanding both the power of compound interest and the difficulty of getting it is the heart and soul of understanding a lot of things….The Big money is not in the buying or selling, but in the waiting.”
Here is another simple example. $100,000 invested in Microsoft shares in Jan 1990, have become $55.1 million in January 2021. This is at a compounded annual growth rate (CAGR) of 28.7%. Holding an investment for 30 years is much difficult than earning a return of 28.7% annually. This is why wealth creation is not so easy.
The power of compounding is driven by 2 factors.
- The rate of return
- The investment time horizon
Rate of return
Rate of return is the gain made on an investment during a particular time period. Each percent difference in the returns becomes a huge difference in long time periods.
Example-You have the following 3 options to invest $ 1,000.
Option A - Fixed deposit generating 5% interest per annum.
Option B – Mutual fund generating 10% return per annum.
Option C – Equity shares generating 12% return per annum.
Here is a table showing value of these investments after 10, 20, 30, 40 and 50 years.
We see that the difference in value of investments between the three options is not too big in first 10 years, but as the investment time increases the difference keeps on increasing.
The difference in returns between Mutual fund and equity is just 2%. But this 2% leads to a huge difference in value of the investment at the end of 40 and 50 years.
At the end of 40 years the value of equity investment is more than 2x of the value of mutual fund investment. As the time increases the difference keeps on increasing. At the end of 50 years the difference in value is around 2.5x.
The Time period
The time period is the period for which the investment is made. It plays a huge role in the power of compounding. It is as important as the rate of return.
Let us understand with the help of another example.
Mr. A and Mr. B are 25 years old now. They both want to retire at the age of 45.
Mr. A invests $ 100,000 immediately at 20% rate of return, while Mr. B waits for 5 years before making this investment. He invests $ 100,000 at the same rate of return (20%) after reaching 30.
When they retire (age 45) the value of their investment is significantly different. Though they invested the same amount at the same rate of return, the value is different because of difference in the investment period, which is 5 years. While value of investment for Mr. A is $3.8 million, it is just $1.5 million for Mr. B.
If Mr. B keeps the investment for another 5 years, its value would become $3.8 million, but by that time the value of investment for Mr. A would become $9.5 million. This is because as the period of investment increases the impact of compounding increases.
As an investor, you just need to start early and learn to be disciplined and be patient. The earlier you start investing the greater will be the wealth creation from power of compounding.