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Understanding the magic of Compounding is crucial in Investing

Do you know how powerful compound interest is? Here are a few quotes that will help explain to you how powerful compound interest is.

Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it. – Albert Einstein

The strongest force in the universe is Compound Interest. – Albert Einstein

I think you might have now got an idea of how powerful compound interest actually is. Warren Buffett credits compound interest for his fortune. A lot many books have been written on this subject.

Compounding is one of the simplest and most powerful elements in investing. Knowledge and patience fule the process of compounding. 

Something one needs to teach their kids in the earliest days would be compound interest not only in terms of money but also in terms of knowledge.

There is an interesting story on compounding which explains this concept beautifully –

As the story goes, when chess was presented to a great king, the king offered the inventor any reward that he wanted. The inventor asked that a single grain of rice be placed on the first square of the chessboard. Then two grains on the second square, four grains on the third, and so on. Doubling each time.

The king, baffled by such a small price for a wonderful game, immediately agreed and ordered the treasurer to pay the agreed-upon sum. A week later, the inventor went before the king and asked why he had not received his reward. The king outraged that the treasurer had disobeyed him, immediately summoned him and demanded to know why the inventor had not been paid. The treasurer explained that the sum could not be paid – by the time you got even halfway through the chessboard, the amount of grain required was more than the entire kingdom possessed.

From the one grain of rice on the first square of the chessboard, the amount increases to the point that by the time you get to square 64, there are over 18 quintillion grains of rice on the board.  (Story has been sourced from Forbes

This is an excellent example of compounding. Isn’t it?

Let’s play with some numbers.

Say for example you invest Rs 10,000 today and you earn 15% per annum return on your investment. This is how your returns will look.

So the 10,000 invested by you becomes 81,371 at the end of the 15th year. Note – you don’t invest anything additional to the 10,000 invested at the beginning of year 1.

The actual magic I feel happens after year 15, let’s check.

At the end of the 40th year, the amount becomes 26.78 lakhs. Just imagine. From some thousands to several lakhs.

The compound interest earned on the above investment turns out to be 26.68 lakhs!

Compounding is more evident in long term.

Compounding is magic, the one who learns it will earn it, and one who ignores it will pay for it!

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