Warren Buffet, one of the world’s most successful investors, has publicly said in an interview that he owes his wealth mainly to three things: being born in America, a few lucky genes and compound interest! Yes, you read that correctly. Turns out, the secret behind successfully growing your wealth multiple times lies in some of the most basic concepts of mathematics that we learnt at school. If you wish to retire a wealthy man, It’s not about how much money you’re currently making but rather how you manage that money. If you’re truly able to understand the power of compounding of money, it has the potential to double your wealth multiple times in the years to come. In this post, I’m going to be mainly talking about what is compounding, how much compound interest can you earn, how long will it take and why you should be doing this ASAP!
Growing up in a business family, my brother & I were always taught that it’s a lot harder to earn your first 10 bucks than getting to a hundred bucks from there. Money pulls more money, they said. Back then this never really made sense to me. But after I was introduced to the concept of compounding in the ‘money world’ I truly understood what my Dad meant by this.
Albert Einstein, the world’s most renowned scientist and genius described ‘Compound Interest’ as the most powerful force in this universe and the 8th wonder of this world.
He who understands it, ‘earns’ it; ‘he who doesn’t, ‘pays’ it.
And thus for some, the simple concept of compound interest is the reason why they never have to worry about making more money; whereas for others, this is the same reason why they’d never get out of debt.
In fact, this is exactly what I love about the power of compounding! It does not discriminate! if you’re rich compound interest can make you richer and if you’re poor it can make you poorer! It doesn’t matter what language you speak, where do you come from, what colour is your skin! Anyone and everyone in this world can earn compound interest! And mind you, it has changed a lot of people’s lives; for good or for worse! So the earlier you understand the power of compound interest the better it is for you!
What is Compound Interest?
Compound interest is nothing but when you reinvest the interest you’ve earned on your principal investment and then over time you earn more interest on this reinvested amount as well. The more time you give it, the more times your money will grow.
To understand this the best, consider the example of a snow ball rolling down a hill! If you’ve grown up in a cold place, I’m sure you’d have made a snowman at least once in your life. And where do you begin? You start by making a snowball! As soon as it’s slightly big in size, you start rolling it around! At first, it seems like nothing at all is happening, but then you’ll slowly see the snowball growing in size. And a little more while later, you’ll notice that it’s growing at a much faster rate than before! Compound interest is nothing but this same concept.
As more and more fragments of snow get attached to the snowball, it increases in surface area and thus picks up more snow along the way. Similarly, as you keep reinvesting the interest you earned in the first year, it’d keep earning you more interest in the coming years. And some years later you’d witness the true potential of this money multiplier effect when your wealth has grown multiple times over from where you started!
Compound Interest V/S Simple Interest
The main and only difference between compound interest and simple interest is that with simple interest you do not reinvest your interest earnings at the end of every year. Thus you earn the same interest amount every year (since the principal amount of investment remains constant). A good example of simple interest is when you lend money to a friend or a family member on interest. In which case, every month your friend keeps paying you a fixed interest until he returns your money.
Whereas with compound interest, your interest earnings are reinvested every time and then you earn interest on that too! Over time you’d see the snowball effect kick in and your original investment amount would’ve grown to be multiple times more!!!
Given below is a table showing a comparative analysis of how much return would an investment of 10,000 bucks generate at 10% Simple Interest v/s 10% compound interest for a period of 5 years.
As you can see, every year compound interest lets you earn slightly more than simple interest. And over time, this difference becomes more and more significant.
For instance, if this same amount had been invested for 25 years instead of 5 years, then compound interest would have earned you a net return of 98,347/- whereas simple interest would’ve earned you just about 25,000/-.
Now you’d probably be thinking, “I don’t have the 10,000 bucks to invest”. And that brings us to our next question:
How much do you need to invest and for how long?
Well, with compound interest, it’s not about how much you invest, but rather how long you remain invested for! The more time you give your money to grow that many times the more return you’ll get. And thus in order to exploit the complete potential of the power of compounding, it’s extremely essential that you start early on in life! The sooner you begin the more doubling cycles your money will see!
To better explain this to you, let me tell you a story of three siblings – Harry, Ron and Hermoine. All three had their own individual personalities and thus different spending habits and financial discipline. All 3 of them invested different amounts for different periods of time. Now let’s see how much return each of them made at the end of a 40-year period.
Before that, here’s a little bit about all 3 of them –
When Harry was growing up, their family was going through a financial crisis. So he was always on a tight budget. He’d do odd jobs and save every penny he can. This habit of saving money stuck with him while he was growing up. And he began saving money quite early on in life. However, he had a tough life ahead of him. He lost his job and after the first few years, he was making just enough money to make ends meet. So he couldn’t continue to save money post that.
When Ron came off age, their dad’s business had recovered the hit and they were leading a simple but stable life. Ron was the free spirited soul who always believed in living in the moment and lived life to the fullest. He’d love to splurge money on unnecessary things and seemed completely oblivious to the concept of saving money as a kid. However, after he grew up, got married and had a family to look after, even he realised his mistake and began saving for the future.
She was the hard-working, smart kid of the lot. Over the years, she worked her ass off and finally managed to climb the ladder to reach a comfortable spot in her career by the time she was in her 30’s. She liked to enjoy the luxuries of life from time to time but she also understood the value of money. Just like Harry, even she started saving money early on in life and continued to do so till she grew old.
Now in order to keep it simple for you to understand and compare, let’s assume that all three siblings saved an equal amount of money every year and earned an equal rate of return on their investment. The only difference being, that all of them started saving at different times in their life.
So let’s say each of them invested an amount of ₹2000 every year at 10% return compounded annually.
Total Investment: ₹16,000 (2000X 8 Yrs)
Begin: 20 Yrs
End: 60 Yrs
Total Investment Time: 40 Yrs
Maturity Amount: ₹5,31,201/-
Total Investment: ₹64,000 (2000X 32Yrs)
Begin: 28 Yrs
End: 60 Yrs
Total Investment Time: 32 Yrs
Maturity Amount: ₹4,42,503/-
Total Investment: ₹80,000 (2000X40Yrs)
Begin: 20 Yrs
End: 60 Yrs
Total Investment Time: 40 Yrs
Maturity Amount: ₹9,73,704/-
You must be wondering how does Harry get so much more than Ron on maturity even though Ron contributed almost 4 times as Harry. Check out the table given below to know how. It’s nothing but ‘Time Value Of Money’!
Power Of Compounding Chart
As you can already see, with compound interest time clearly wins over the amount. Harry invested a total of merely 16,000 bucks and yet he made 40% more than Ron who in turn put 4 times more what Harry could contribute. On the other hand, even though Hermoine contributed 5 times what Harry invested and yet she ends making not even double what Harry made.
So, what’s the moral of the story? When it comes to wealth creation, it’s a race! A race against time! So the earlier you begin, the wealthier you would be in future. This is because the earlier you begin, that many more doubling cycles your money gets to see!
Everybody knows what a huge portfolio has Mr. Warren Buffet been able to build for Berkshire Hathway. His personal holding in it goes as high as upto $90 billion! But do you know how was that possible? Because he started at the tender age of 14! He bought his life’s first share when he was just 14 years old. And then there was no turning back! Today he is 85 years old. Even if you consider an average return of 10% on his investments a year, he’d have seen 10 doubling cycles over the years!
So his initial very first investment would have doubled 10 times by now! Seems too small a number? Ok, let’s put it in perspective. Do you know how much would you get if you just double just ₹10 ten times? You’d get a whopping ₹10,240 bucks! That is the power of compounding!
How did I arrive at this number?
The answer to this question is just plain multiplication and division! Yes! There are two simple tricks I’m going to show you using which you can easily calculate how long would it take you to double or even triple your money:
The Rule Of 72: HOW LONG YOUR MONEY TAKES TO DOUBLE?
The rule of 72 as it’s famously called, tells you nothing but how long would it take your money to double when invested at a certain rate of compound interest. It’s as follows:
No of years it takes to 2X your money = 72/Rate of Compound Interest
10,000 invested at 10% compounded annually, would double your investment to 20,000 in 7.2 Years (72/10)
Similarly, if you want to triple your money:
The Rule of 115: HOW LONG DOES IT TAKE TO TRIPLE YOUR MONEY?
No of years it takes to 3X your money = 115/Rate of Compound Interest
10,000 invested at 10% compounded annually, would TRIPLE your investment to 30,000 bucks in 11.5 Years (115/10)
So now let’s go back to Warren Buffet. So as you read earlier, his first investment would’ve seen 10 doubling cycles till now. That is because his first investment was made when he was 14 and today he is 85! So as per ‘The Rule of 72’, considering an average yearly return of 10%, in 72 years his money would’ve doubled at least 10 times!
Ok, so by you know what is compound interest, time value of money, blah blah blah. But you still don’t know the most important thing!
And that is,
HOW CAN YOU EARN COMPOUND INTEREST?
There are numerous ways to earn compound interest. But first, let’s tell you about which ways should NOT be in your preference list.
A lot of people are in the misconception that parking your idle money in a savings bank a/c in a good way to earn interest on your money.
But let me tell you, it’s not. Banks pay you the least return on your money. Most banks in India pay up to 4% annually and I guess Kotak Mahindra Bank pays about 6% annually.
Firstly, the return banks pay you is very less and secondly, you’re liable to pay income tax on your yearly interest earnings. So based on which tax bracket you lie, you lose that much money in the form of tax.
Moreover, the interest rate of a savings bank a/c is not even enough to outpace the rate of inflation.
So let’s get to it. These are my top two recommendations to invest your money safely and earn a decent return on your investment every year.
Let me warn you beforehand, here we’re looking at the stock market only from an investment perspective and not long-term/short-term trading. Mind you, stock trading is a dangerous game unless you’re 100% sure of what you’re doing. So I’d say stay away from trading.
Use the stock market only as a means to park your wealth safely. In simple language, stick to only bluechip companies who’re known to have performed consistently well historically.
Most such companies have a steady growth and are safe investments. To name a few, I’d companies such as TCS, Reliance, Infosys, Eicher Motors, MRF, etc (all these are names of Indian companies listed on SENSEX).
Now everybody knows, these are names of some companies that have been around since forever and can never go down to the ground. Not only that, these companies are historically known to give you a steady average return of upwards of 10%.
Not only that, you even get added returns in the form of dividends every year and bonus issues too sometimes.
Ok, let’s consider the example of TCS or TATA Consultancy Services, India’s largest company as on today by market capitalisation:
- The TCS stock was first listed in August 2004 at an issue price of 850/-
- So let’s assume you had invested just 850/- and bought just one share of TCS.
- Till now TCS issued bonus shares in the ratio 1:1 thrice, once in July 2006, the second time in June 2009 and the third time in June 2018.
- So that means if you had just bought 1 share of TCS in 2004 you’d have 8 shares of TCS today.
And considering today’s closing price of TCS which is 1983.90/-, your original investment of 850/- rupees in 2004 would’ve grown to 15,871/- (1983.90 X 8) by now already!!!!
A whopping 18 times!!!! And guess what, you’re just in your 14th year of investment as of now in 2018. In other words, your money already doubled 4 times in 14 years by now! Which means speaking in terms of compound interest, you’ve earned a staggering 20% return on your investment annually till now.
Even if you do a little bit of research on your own, you’d find that this math holds true for the majority of the blue-chip companies’ stocks.
The second most attractive way to earn compound interest is the real estate market. Now, just like bluechip companies when it comes to the stock market, in the real estate market I’d say your bluechip stocks would be properties located in the heart of a metro city such as Mumbai, New York, Paris, etc. or in a region of high industrial importance.
We all know that these are not the kind of spots that would ever go out of demand. For instance, if you own a piece of real estate at Times Square in Manhattan, you don’t need a real estate expert to tell you that your investment is pretty sorted for the years to come.
Even if there is a transformation in the surrounding neighbourhood, you’d get enough time to exit and reinvest your money elsewhere.
Now coming to appreciation in the value.
Historically, we’ve known some of the world’s top real estate investment hubs to give an average return of more than 10% every year. A quick Google search would give you the historical real estate rates of any major city in the world and you’ll find this to be true for most metros in the world.
I’m not saying that the real estate market can never crash. It has, in the past due to various factors. But at the same time, it’s also true that it will definitely recover very quickly after the crash.
I mean, think about it, people are born every day and we’re facing shortage of space in every major metro city in this world. In such a scenario, it’s only a matter of time and the real estate markets would bounce back to its true valuations after a crash.
Another advantage of investing in bluechip real estate is that you earn added rental income as well. This rental income, in turn, can be used to pay-off the EMIs in case of a home loan or you could reinvest this money in the stock market to earn more returns on it.
P.S: Here, I’ve just broadly mentioned ways to invest your money and earn compound interest on it. Watch out for a separate post later on LMFL that’d talk about investing in detail!
A recent study distributes the global population into 3 groups based on the total wealth they possess. They are grouped as follows:
5% – This number represents the people who come from families with lots of generational wealth.
15% – Represents the middle class
80% – These are those people who have to work hard day in day out to make ends meet and when they get old, they have to depend on the government to survive.
Now it’s on you to decide where do you want to be!
And We all know, not every country on this planet today has got a solid social security programme to look after it’s citizens in their later years.
So you’ve got to START asap if you wish to have a nice, comfortable and an independent life throughout.
So it’s you who’s got to decide for yourself.
Do you want to work all your life to make money or do you want to make your money work for you?
And the other most important thing. By now you must already know how important it is to start early!! But I’d still like to stress on that at the end of this post. If you want to truly unleash the power of compounding it’s quintessential you start saving ASAP!! The earlier you begin the wealthier you will be!
Let me know in the comments section how much are you willing to start investing with and I’ll give you some ideas 🙂
Happy Saving 🙂