Power of Compounding

I came across this article about ‘Power of compounding’ in DNA money, Oct 5^th 2011 DNA newpaper’s financial and economic news section. I found it very interesting and thought you too would like it and may benefit from it, so reproducing the whole article here:

Power of Compounding:

“In the book, ‘Once upon a Wall Street’, Peter Lynch, one of the most successful mutual fund managers that wall street has ever seen, narrates a story.

Consider the Indians of Manhattan, Who in 1625 sold all their real estate to a group of immigrants for $24 in trinkets and beads. For 363 years the Indians have been the subjects of cruel jokes because of it- but it turns out that they may have made a better deal than the buyers who got the island. At 8% interest on $24 (note: let’s suspend our disbelief and assume they converted the trinkets to cash) compounded over all those years, the Indians would have built up a net worth just short $30 trillion, while the latest tax records from the Borough of Manhattan show the real estate to be worth only $28.1 billion.

Give Manhattan the benefit of doubt: That $28.1 billion is the assessed value, and for all anybody knows, it may be worth twice that on the open market. So Manhattan’s worth $56.2 billion. Either way, the Indians could be ahead by $29 trillion and change!

This little story conveys you the power of compounding and the fact that the earlier you start investing the better it gets.

Illustration

Let’s try and understand this through an example of two friends Ram and Shyam. Both start working at the same time at the age of 23. Ram starts saving when he turns 25 and invests Rs. 50,000 every year. Assuming that on this he earns a return of 10% every year, at the end of ten years, Ram has been able to accumulate Rs. 8.77 lakh.

However, due to financial constraints Ram is not able to invest any more money after the 10^th year. At the same time he does not utilise the fund that he has already accumulated, hoping to live off it when he retires.

He lets the Rs. 8.77 lakh grow and assuming that it continues to earn a return of 10% p.a., he would be able to accumulate around Rs. 95 lakh by the time he turns 60. So the Rs. 5 lakh (Rs. 50,000 x 10 years) he had invested in the first ten years of his working life would have grown to Rs. 95 lakh. This, even though he stopped investing entirely after the first ten years.

Now let’s take the case of Shyam. Shyam believed in enjoying life, spending money recklessly rather than save regularly.

However at the age of 35, reality suddenly dawns upon him and he starts putting aside Rs. 50,000 every year. Unlike his friend Ram, who stopped after the first 10 years, Shyam religiously invests the amount each year for all of 25 years i.e. till he turns 60. Now, assuming he also earns a return of 10% per year on his investments, in the end, Shyam would have managed to 

accumulate Rs. 54.10 lakh.

Putting it differently, even after investing Rs. 50,000 regularly for 25 years, Shyam has only managed to accumulate Rs. 41 lakh lesser in comparison to Ram. Remember Ram has ended up investing only Rs. 5 lakh in total over the 10 years that he invested. In comparison, Shyam over the 25 years invested Rs. 12.5 lakh (Rs. 50,000 x 25 years). So even by saving two-and-a-half times more that Ram, Shyam has managed to build a corpus which is 43% lower! This happened because Ram started investing earlier which in turn allowed the money to compound for a greater 

period of time.

Also, as the corpus grows, the impact of compounding is greater. Ram as we know had managed to accumulate Rs. 8.77 lakh after 10 years after which he stopped investing, allowing the accumulated corpus to compound for 20 years more. In other words, the total life of the investment was for 30 years. However had his investment time-frame been till he turned 55 i.e. had the money compounded for 25 years instead of 30, then at the end Ram would have accumulated a corpus of around Rs. 59 lakh. By choosing to let his investment run for just an additional five years, Ram managed to accumulate Rs. 45 lakh more.

Real life illustration

In terms of a practical example, let’s take the case of HDFC Equity fund. The 5 year return of this fund is around 13% p.a. On the other hand from inception (December 1994), the fund has returned 21% p.a. Now, had an investor invested say Rs. 50,000 five years back, the investment would have grown to around Rs. 91,000.

However had the investment been made at the inception (allowing the money to compound over a greater period of time) the investment would have grown over 24 times to around Rs. 12 lakh.

To sum up, Albert Einstein himself called the power of compounding the 8^th wonder of the world. In this article we have given various examples of how potent this power is when combined with its ally—Father time. It’s never too early nor too late to begin investing. Or to put it differently, better late than later.”

After reading this, I can see where I am, my situation being pretty much similar to ‘Shyam’ of the example! But since now I know about the power of compounding, and as they say better late than later, I intend to chalk out my own financial planning. Hope this article will make us think about investments and financial planning a bit more seriously, especially for the new ones who have recently come out of their colleges & have started earning!