IntroductionOne of the most basic premises of investing is that your money multipliesmanifold over time and this multiplication of money is normally referred toas the "Power of Compounding". The compounding effect of investing yourmoney is perhaps one of the most important aspects to achieving long-termwealth. For it to work, you must be a long-term investor with lots ofpatience.
When you invest money, it earns interest (or returns). If you keep the interestinvested, then it does not sit idle while only the original investment sweats itout. The interest earns interest too and then the interest on the interest earnsinterest again.This is the beauty of compounding. That is what made great men like WarrenBuffet extol the virtues of "compounding".
What Does Compounding Mean To An InvestorLet us understand this with the help of an example. Mr. A, Mr. B and Mr. Care three friends with same background and age:On his tenth birthday, Ms As father gave him Rs. 100. He wisely invested themoney that earned him an interest of 15% every year.Mr. B won Rs. 200 as prize money when he was 16 years old. His friend, Mr.A, advised him to invest his prize similarly. When Mr. C earned his first salaryat the age of 21, he salted away Rs. 400 in the same instrument as Mr. As.After reaching the age of 60, all three decided to withdraw theirinvestments. Who do you think realized the most from his investment?
You will tend to think its Mr. C, right? After all, he invested four times thesum that Mr. A had invested. So what if he had invested the money tenyears later? He did earn interest for 40 years after that. But think again.Mr. A made the most out of his investment, in fact, his Rs100 was worthRs108,366. On the other hand, Mr. C Rs400 was worth only Rs93,169.It simply means that the longer you stay invested the more money you willmake.Now you know why Mr. A made more money than Mr. B and Mr. C.
Let us try one more example to understand the impact of interest rates.Let us assume Mr. A, Mr. B and Mr. C invested Rs100 for ten years.However, all three of them earn interest at different rates. Mr. A earns20% while Mr. B earns 15% and Mr. C manages a 10% interest rate.What is the amount each one of them will have ten years hence?Mr. A will have Rs619 while Mr. B will have Rs405. while Mr. C will havethe least Rs259 in ten years. Have you noticed something though? Whilethe interest rates differ by just 5%, in ten years the worth of the originalcapital, Rs100 would be vastly different.That is another way of understanding the power of compounding or thepower to grow exponentially.
The Rule of 72The rule of 72 is an easy way to find out in how many years your moneywill double at a given interest rate. It is very simple, divide the number inthe title by the interest percentage per period to get the approximatenumber of period needed for doubling.Suppose the interest rate is 15%, then your money will double in 72/15=4.8 years. In case, the interest rate is 20%, then the money will double in3.6 years.Thus the moral of the story is the longer you stay invested the moremoney you will make.
The power of compounding when applied to the stock market can make yourich many times over and sooner than you can imagine. That is becausehistorically, the stock market is known to give the highest return per annumover long term compared with the other investment instruments.So, if you dont have an exposure to the stock market yet, start right now asaccording to the power of compounding, the longer you stay invested themore money you will make.
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