How often have you heard the statement “you should make money work for you rather than you working to make money”? This sounds very appealing, so we often wonder about the ways to make money work for us than the other way around. Is it an outcome of making investments in the right asset class? Is it about timing the entry and exit in an asset class so that you always end up investing when the asset is quoted at a lower price and sell when the asset reaches its highest value? While all these may sound too good to believe, there is a practical way to make money work for you. All it takes from you is to understand the larger picture and being persistent with your investments. Do you know what it is? We are talking about the power of compounding. A rupee earned today is worth more than a rupee earned tomorrow. Similarly, a rupee saved today is worth more than a rupee saved tomorrow because of the compounding effect of your investment.
As we have seen in our earlier blog on Financial Independence (Financial Independence – Start the Journey with a simple step!), saving money is the first step to start the journey towards financial freedom. Now to add the power of compounding, you just have to do the added step of investing the money you saved for a longer duration. Keep repeating this process of “save & Invest,” the power of compounding manifests itself over time to bless you with a considerable amount of corpus. How does this work?
There is an interesting legend about the power of compounding! There was once a king who was a big chess enthusiast. He challenged the wise men for a game of chess and if he lost, the king accepted to reward them with anything they asked for. One day the king lost the game to one of the wise men in his kingdom and his opponent asked for grains of rice. Being a wise man, he did not mention the actual quantity. The quantity of grains was to be determined in the following manner:
The king was to put a single grain of rice on the first chess square and double it for every consequent square. The king accepted the request and started placing rice grains according to the arrangement: 1 grain on the first square, 2 on the second, 4 on the third, 8 on the fourth and so on.
Following the exponential growth of the rice payment, the king quickly realized that he would be unable to fulfill his promise because on the twentieth square the king would have had to put 1 million grains of rice. On the fortieth square, the king would have had to put 1 billion grains of rice. And, finally, on the sixty-fourth square, the king would have had to put a huge quantity of rice equal to about 210 billion tons by weight.
You make an investment of, say 10000 Rs in a fixed deposit with a bank and you earn an interest of 10% per annum for 5 years. You have two choices. Take the interest of 10% i.e., 1000 Rs every year and get your 10000 Rs back after 5 years. In this case you would have a total of 5000 Rs as interest and 10000 Rs as principal. Let us say you do not take this interest every year and instead ask the bank to re-invest the interest every year i.e., after the first year the interest of 1000 Rs is re-invested, and your principal becomes 11000 Rs instead of 10000 Rs. Then the magic begins! You earn the second year’s interest of 10% on 11000 Rs now instead of 10000 Rs. So, after the end of the 5th Year, you will have a total of 16105 Rs (10000 Rs of principal and 6105 Rs of returns). In the earlier choice you will have a total of 15000 Rs only (10000 Rs of principal and 5000 Rs of interest payments).
Imagine doing this for a period of not just 10 years, but for 20,25 and if not 30 years. You would have struck a fortune at the end of the period. Did it happen with a “Smart” investment choice? Did it happen by periodically entering and exiting investments? No. You would have made this wealth by not interrupting the process of compounding. When returns earned from investments are reinvested to generate more returns, it results in compounding of returns. Compounding is a money multiplier strategy used in investments. By making investments and investing the returns earned, wealth of a person can be scaled drastically.
Let us look at how compounding works when you make a recurring investment. This involves investing a fixed amount at a certain periodicity – say monthly. In the mutual fund world of investing, this process is called Systematic Investment Plan (SIP). SIPs are an ideal method of realising the power of compounding without having to worry about market timing. So let us say you make 10000 Rs investment every month for a period of 10 years in an equity oriented mutual fund. The average SIP returns of Equity fund universe over a 10-year period has been approximately 14%. 10000 Rs allocated every month would have grown to 26.2 lakhs against a total investment of 12 lakhs at the end of 10 years.
Whoa! A huge amount, right? So, doesn’t it make sense to harness the power of compounding by periodically saving and investing your money? No wonder Albert Einstein remarked the power of compounding as the “Eighth wonder of the world” and those who understands it, earns it, and those who do not, pays it. Now let us all harness this power to make money work for us. This is not a secret recipe for wealth creation, but a practical approach that only demands persistence form the part of an investor. So, keep saving, invest the savings and never interrupt the process of compounding.
Savings and Investing are baby steps towards financial independence. All we need to do is to start and have the capability to move forward. The size of the step taken does not matter. A Journey of 1000 miles begins with a single step. So, take your first step now and let your journey be fueled by the power of compounding.