~ By Harsh Agarwal and Shauryae Bhatnagar
Rewind to the times when we were in the eighth standard and had the compulsion to study simple interest as well as compound interest? Well, the lectures you found boring as a teenager are a secret behind the journey of every successful person and the very essence of every part of life. Let’s build upon what compounding actually is and how it runs a large number of commercial activities.
Let’s first understand what compounding is. It is a process in which interest is accredited on the principal amount as well as interest already earned on the principal in the previous calculation period. Basically, it means the interest on interest.
Sounds very technical and hard to comprehend? No worries, let’s understand through examples from daily life.
Let's take an example of habit formation, say exercise and fitness. The first question you may ask is how exercising daily is compounding and where is the interest? See friends, compounding is a concept that makes life better off, you invest something (known as the principal) that will accumulate over a period of time but you also earn something as a gain on the principal (known as interest).
Exercising daily is your investment as a principal which eventually helps you to remain fit and fine. Now talking about the interest on this principal, it is the efficiency that generates in doing the routine work. The more you invest, the more you gain. Here we have to consider the time factor also as an early start leads to more gains. You also have to be consistent with your investment (here, the exercise) to keep benefiting from the interest generated (here, the efficiency).
So the above example is a very implicit and basic example from daily life to understand compounding. Now let’s delve deeper into the investing world with some more examples.
You must have heard your parents or anyone exclaiming that they should have started investing earlier with them stating overwhelming monetary figures. This conversation implicitly points to the power and magic of compounding, which most people fail to implement, accompanied with regret later. Thus compound investing is not an exaggerated thing, but an imperative step towards a progressive life.
Let’s carry our discussion forward with some analogies. All of us must have been friends with a piggy bank, putting notes and coins in it and waiting eagerly for the time to break the piggy bank to see some wealth accumulated (though some smart buddies are able to pull out some notes from the minute opening). Here the money you put is the principal but a major drawback is that there is no interest gained. This is the same with the money locked idle in a locker at home. So the question is how compounding is achieved in the finance world? Here comes the indispensable existence of different investing avenues and the most heard one is depositing money in banks. There are other investment avenues also guided by their own intricacies and fundamentals that make the concept more intriguing. But to simplify things we will understand through a numerical.
Let’s say you deposit Rs 10,000 in a bank at the age of 25 and deposit an additional Rs 10,000 each successive year at an interest rate of 10%. After 10 years when you’re at the age of 35, your total principal amount invested would equal Rs 1,10,000 (including the initial deposit), and interest received upon that investment would equal Rs 85,311. Now, if you stop investing Rs 10,000 each year after turning 35, after 30 years when you are 65, the amount would be Rs 32,33,566. That equals a rate of return of 32 times! This is how big the rate of returns can be with compounding.
Similarly, your friend invests Rs 10,000 every year at the same interest rate of 10% but starts investing at the age of 35. He continues to invest Rs 10,000 every year till he turns 65. The total amount invested would equal Rs 3,10,000 (including the initial deposit). However, the total amount he would be having at the age of 65 would be only Rs 18,18,776. Despite investing about triple the amount that you did, your friend ended up retiring with only about half the amount that you saved! That’s how important it is to start investing right now.
The above examples clearly show that compounding has such power and magic that it can turn rags into riches. Compounding is that invisible force that guides the working of minute aspects of life. However, it’s never too late! The key element is to have patience and start with as much amount as you can. So what are you waiting for? Invest your savings today and enjoy the magic of compounding.