Nov 17, 2015 11:59 AM IST | Source: Moneycontrol.com
Three amazing compound interest lessons you must not miss
Compound interest can create wealth for you, provided you use it to your advantage.
“Compound interest is the eighth wonder of the world. He who understands it, earns it, he who doesn't, pays it.” The most intelligent man on earth, Albert Einstein’s quote speaks volumes about the power of compound interest as it can truly do ‘wonders’ in your financial life.
The longer duration of time you stay invested for, the more benefit you will receive from compounding. Take the example of an avalanche, it starts off as snow, turns into a snowball and eventually grows so large in size that it destroys everything in its path. This is the power of compounding.
Thus, it is not the timing of investment but the time you stay invested that creates great wealth!
Let’s look at three lessons with factual and accurate calculations to explain how compound interest helps to create large chunks of wealth.
Lesson 1 : ‘Regret of 5’
At the age of 25, two college friends, Ragu and Ronny have settled down with their respective jobs and are living on their own. They both earn similar salaries. But when it comes to savings, they change their tracks. Ragu thinks that he should save a certain amount towards his future while Ronny thinks it's too early to even think about saving and enjoys living his life lavishly. Consider a scenario where Ragu and Ronny decide to retire at the age of 65.
Ragu starts investing for retirement at an early age of 25 via a monthly SIP of Rs.10, 000/- for 10 years which grows to around Rs.25.90 lakh at the end of 10 years and then lets the lump sum amount of Rs.25.90 lakh to grow till he retires (Age 65).
Ronny starts investing at the age of 30 via a monthly SIP of Rs.10, 000/- for 10 years which grows to around Rs.25.90 lakh at the end of 10 years and then lets the lump sum amount of Rs.25.90 lakh to grow till he retires (Age 65).
Ragu & Ronny both have invested for 10 yrs but Ragu started his investment 5 yrs early & thus created Rs.6.34 crore more. The lax attitude of Ronny to delay his investment by ONLY 5 years has caused his corpus to be almost HALF the amount of his friend Ragu.
Lesson 2: ‘Magic of 20’
The table below signifies the powerful concept of compounding. Mr. Sodhi has Rs 1 lakh to invest as a lump sum. He invests it in an investment avenue that has the potential of giving him 14% return on a CAGR basis. One can see that during the initial phases of investment, the wealth growth factor does not increase by huge margins.
Mr. Sodhi stays invested and eventually is rewarded for his patience. Mr Sodhi’s initial investment of Rs. 1 lakh grew to Rs. 13.74 lakhs after 20 years but at the end of 30 years he has Rs. 50.95 lakhs! Around the 25-30 year period the beauty of compounding takes over and investments grow at an overwhelming rate! Such substantial gains can only be realized if one stays invested for the long term.
Lesson 3: ‘Power of 7’
Let’s take a scenario where Mr Ganesh invests Rs.10, 000/- on a monthly SIP basis. The graphs below show a comparison of his returns if he invests in FUND A giving 7% returns or Fund B giving 14 % returns on investment for 10 years, 20 years and 30 years respectively. Looking at the graphs below one can see that in the first 10 years there is not a vast difference between the corpus value of investments giving 7% and 14% returns, but as his investment tenure increases from 10 years to 20 years and eventually 20 years to 30 years, the difference between his investments increases drastically. After 20 years the difference is almost Rs.78 lakhs while after 30 years the difference is 4.27 Cr! This is the power of 7%. Even though investments that are giving lower returns in the earlier stages might look to be almost on par with those giving higher returns, it is important to look at the bigger picture. Here what is more important is the concept of asset allocation. In simple words it means to manage your risk tolerance with optimum return expectation. Investment in fixed deposits can earn you around 7-8% but a proper mix of other asset classes like real estate & equity can lead your return expectation towards 13-14%.Right asset allocation as per your risk appetite is always an added advantage for long term wealth creation.
To sum up the lessons learnt, ‘Regret of 5’ taught you to start investing early. ‘Magic of 20’ clearly shows the advantage of staying invested for a longer period of time. And finally, ‘Power of 7’ explains the importance of asset allocation to gain higher returns. The wealth that compound interest helps to create can clearly be seen in these lessons. One should look to apply these in their investment decisions. Those looking to gain maximum advantage from the power of compounding must look to invest for a long term.
To end, here is a famous quote by Warren Buffet, "Someone's sitting in the shade today because someone planted a tree long time ago." So plant your seeds (investments), give it some time and let the power of compounding show its magic.