Power of Compounding

We have all heard the Rice Grain and Chess Board story. While the characters and proponents vary across regions the storyline largely remains same. When the emperor was shown the game of Chess by the inventor, he was overly impressed and proclaimed, “Name your reward”. The wise man calmly requested for a grain of rice for the first square of the chessboard, two grains for the second square, four for the next and doubling this way for each of the subsequent squares. The emperor laughed it off as a meagre price for a brilliant invention and ordered his treasury to comply with the request. The first square one grain, second two grains, on the5th square the number of grains were 65,536 and 6th square the numbers were 4,29,49,67,296. After about only 20 squares, the treasurer reported that there were not enough grains in the kingdom to fulfill the request.

Compounding, as we know takes place when Returns or Interest generated on the Principal Amount in the first period is added back to the principal to calculate the interest or returns for the subsequent period. Interest for each period is calculated on Interest + Principal and this is repeated for till maturity.

If we invest Rs10,000 annually for a period of 10 years @10% per annum the maturity is slightly lower than if invested @11% for the same period. However, if the investment period is increased by just one year to 11 years, the maturity then is higher than both the previous options. Yes, Systematic Investment Plans are prone to market volatility in the short term but in the long term an extra year or two does the magic.

Compounding can have a profound impact on our lives. Its omnipresent, we know it and yet at times we are oblivious to it. Investing is no different. The discourse is dominated by strategies, tips, advice all aiming that extra return. While we are keen to identify the best schemes and evaluate their performances, we often overlook the period of investment.

Yes, we should study the factsheets and seek advice on selecting the right scheme but if we could also prepone our investments sometimes only by a year, it might significantly impact the maturity. Start Early….it impacts the maturity for sure, check impact with the SIP Calculator.

Once you start your SIP or any investment stay on course. Compounding and discipline go together. Whether it is learning a new skill, acquiring a habit or wealth creation the effect in the initial period is barely noticeable. It is only after half the path is covered that we notice some impact and as we cover some more ground the change becomes rapid and noticeable. For an SIP of twenty years, the appreciation in the first five years or so is negligible. Appreciation after 10 years is definitely noticeable, the returns after 15 years become delightful and if you stay the course returns thereafter are stellar. This is true for any mutual fund scheme, more so Equity Mutual Funds.

We have always known Compound Interest but probably did not appreciate the power of compounding fully. Whether its our investments, learning a new skill or simply acquiring a good habit, compounding is always at play. One of the greatest genius of our times reportedly suggested, “Compound Interest is the 8th wonder of the world. He who understands it earns it. He who doesn’t pays it.” Give time to your investments and remember, “Time spent in the market is more important than Timing”.

Summary:

  1. Start Early. Simple yet Powerful.
  2. Stretch you budget slightly each time you invest.
  3. Stay the Course. Benefits do not accrue instantly but SIP returns in the long term can be stellar.

 

Disclaimer: Mutual Fund returns are subject to market risks. Read all scheme related documents before investing.

 

Read More:

  1. Common Mutual Fund Terms
  2. Systematic Investing – SIP, STP, SWP
  3. Life Insurance Buying Guide