Understanding the Power of Compounding in Investing: If you understand the power of compounding, you can make amazing returns from your investments and live a financially healthy life. Albert Einstein, one of the most successful scientists of all time considers ‘Compounding’ as the eighth wonder of the world. Truly so. However, many investors are still ignorant of the real power of compounding.

In this article, we’ll look into the importance of compounding and also answer why understanding this key secret of finance can change your life. Let’s unravel the Power of Compounding. Keep Reading.

The King who Lost Everything to Compounding

At a very young age, my grandfather told me a story explaining the power of compounding. Though I enjoyed the story, it was much later when I learned what exactly was the lesson inside It. He told me the following story to explain the concept of compounding which I am going to narrate now:

“Once upon a time, there lived a Rich King in a Prosperous country. He was well known all over the country for his generosity and trustworthy words as he always kept his promise no matter what. Because of the nature of the King, he was widely favoured by people in his kingdom.

All the people in his kingdom were very happy and leading peaceful life. However, there was a cunning burglar in the capital city. Once, when the burglar was trying to steal some jewels from one of his minister’s house, he was caught red-handed. The burglar was presented in front of the King to get his punishment. Coincidently, at that time, the king was playing ‘CHESS’ with his prime minister.

The punishment for stealing in that country was death. Nevertheless, the burglar knew about the generous nature of the king. He demanded one last wish from the king. The king agreed and said that if it was in his power and goodwill, he will fulfill the Burglar’s Wish.

The burglar said, “O Powerful and honorable King! I knew that the punishment for stealing in this country is death. However, what else I could do. I tried to steal some jewels only because I could not see my family suffering from hunger. After I am gone, I just wish them to have enough food to live for a few days before they manage it themselves.”

He further added, “My wish is simple, my King. As I disturbed you while you were playing chess, I’ll keep my wish related to your game. I only wish for the sum of grains equal to the total squares in your chessboard but doubled every time. What I mean to say is that I wish to get one grain of rice for the first square of the chessboard, two grains for the second square, four grains for the third square, eight for the fourth square, and so on for all the 64 squares.“

The King regarded this as a small wish and granted the burglar’s wish without thinking much. The King promised that the Burglar will be prosecuted only after his last wish was fulfilled. However, a week later, the king’s treasurer informed the King that even his whole kingdom doesn’t produce as much rice as promised by the Kind. Moreover, the quantity of the promised rice might not even be produced by combining many neighbor countries.

In the end, the King was forced to give his entire kingdom and all his possessions to the burglar, as he could not keep his promise. This is the power of compounding.”

…….

I remember my grandfather’s serious words after the story “The strongest force in the universe is Compound Interest.”

The Power of Compounding

Benjamin Franklin once wrote: ”’tis the stone that will turn all your lead into gold Remember that money is of a prolific, generating nature. Money can beget money, and its offspring can beget more.‘‘

Power of compounding is reinvesting (or compounding) of income on the initial amount invested and also on the accumulated interest over previous years to grow the amount invested year over year. Here, you make interest on your interest earned.

Now, you might think what’s so great about this. Even a fifth-grader can define the term. Yes, you’re right. A 5th grader may also know compound interest. However, practical implementation of the Power of compounding is not known to him.

Now, let’s see how the concept of compounding actually works.

Suppose Rajat invested Rs 1,00,000 at the age of 20 and locks all his investments till retirement. The condition here is that he gets compound interest on his investment every year. On the other hand, his friend – Arvind, however, doesn’t make any investment till he is 40. At the age of 40, Arvind invested Rs 1,00,000 and locks it till the age of 60.

The table below shows how their investments would turn out when both are 60, assuming that the growth rate is 15 percent compounded per annum. The results are eye-opening.

On retirement, Rajat will get whooping Rs 2.6 Crores. On the other hand, Arvind will only get Rs 16 lakhs. Therefore, over 16 Times return on the Investment value for Rajat compared to Arvind.

From the above example, you can understand that compounding is a simple, but very powerful concept. Why? Because compounding is similar to a multiplier effect since the interest that is earned by the initial capital also earns an interest, the value of the investment grows at an exponential rate rather than an arithmetic linear rate. The higher the rate of return and the time period, the steeper the curve.

Here is a chart of returns on compound interest vs simple interest. The principal amount is Rs 1 lakhs and an annual return on both simple and compound interest is 15%. The time period considered here is 20 years.

Closing Thoughts

In this article, we discussed the power of compounding. A high compounded growth rate and a longer time period on your investment can help you build a huge corpus. That’s why compounding is considered as the secret of building wealth.

That’s all for this post on the Power of compounding. I hope you’ll keep in mind the power of compounding when you are making your investments. In addition, the next time you plan to borrow money on credit cards or from high-interest loans, also remember that compounding is working against you in these cases. Invest smartly and Happy investing.

Kritesh Abhishek

Kritesh (Tweet here) is the Founder & CEO of Trade Brains & FinGrad. He is an NSE Certified Equity Fundamental Analyst with +7 Years of Experience in Share Market Investing. Kritesh frequently writes about Share Market Investing and IPOs and publishes his personal insights on the market.