What is the law of compounding?

What is the law of compounding?

There are two types of people in this world, those who understand the Power of Compounding in Investing and those who don’t. Almost everyone who invests money claims to understand the Power of Compounding but very few actually do.

Let’s see if you really understand it, let me ask you a simple question. Let’s assume you’re in a job interview and the interviewer gives you two options:-

Option 1. You either can choose to get Rs. 10,000 every day for 1 month (30 days).  

Option 2. Or you get Rs. 0.01 (1 Paisa) on first day, then double the amount of the previous day for 30 days. For ex. starting from Rs. 0.01 (1 Paisa), then Rs. 0.02 on the second day, then Rs. 0.04 on the third day. Which option would you chose?

You can take a moment to think about it and guess your answer before scrolling down.

Decided? Let’s reveal the answer.

If you chose the first option then you get a total of 3,00,000 rupees. Not a small amount, huh? Whereas if you’ve picked the second option, then total amount would be some like this:-

As you can see, the amount on the 30th day would be more than 53 lakhs. Moreover, the interviewer said you get all the amount in these 30 days, so you can add up Rs.53,68,709+ 26,84,354+ 13,42,177 and so on. It’s definitely way more than just Rs.3,00,000 from the option 1, isn’t it?

Here’s an interesting story from ancient days, from where it all started.

Once upon a time, there lived a wealthy king. He had all the resources available in his kingdom. There was one wise man in his kingdom who invented “chess”. When his game of chess was presented in front of the king, he was delighted and asked the wise man to order any gift from his kingdom. The man made a simple request. 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. Something like this:

The king was confused as this was such a small request but agreed happily. He ordered his treasurer to pay the agreed gift. A week later, the wise man went to the king’s palace and asked why he had not received his reward. When the king questioned his treasurer, he was informed the request could not be fulfilled as they don’t have enough rice in their entire kingdom.

The king was surprised and questioned how is that possible. The treasurer then explained that by the time they reached the end of the chessboard (which is the 64th box) the total number of rice grain required will be 18,446,744,073,709,551,615, much higher than most would expect. (Even an agriculture wealthy country like India doesn’t produce that amount of rice yearly in today’s date).

This concept is mostly used in relation to compounding interest where the previous amount gets added on top of the new one. However, how is it applicable to us in today’s world?

Since the amount is getting doubled everytime, which means there is 100% rate of return on the principle. In reality, we don’t get 100% return so easily.

Now let’s fast forward to today’s world and take an example of two friends: Rocky & Sunny who invests same amount i.e. Rs.1000 every month.

Rocky started investing at the age of 25 whereas Sunny started investing 5 years later i.e. at the age of 30. They both remained invested until the age of 60 and you can see the difference in return below.

As you can see, there is only a difference of 5 years and Rocky got almost double the returns. This is no trick or gimmick; this is pure math.

This is why a genius of his time quoted:

“Compounding is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”

-Albert Einstein

 Personally, my goal is to achieve financial freedom; investment diversified in different sectors and field so no matter what the condition of our economy is, I’m going to get stable income to cover my family expense.

You may have a different goal like to become rich, buy a house, a car etc. or no goal but just to create wealth, which is good. Everything starts with a desire and it will complete with investing. I’ll tell you why:

If you have a lot of funds in your bank account then it’s just losing the purchasing power and multiple opportunities for you are lost.

If you don’t have enough money left at the end of the month then you need to take a step behind and learn how to spend smartly then invest.

“Remember, investing is boring; spending is interesting.”

-Mohsin Mansuri

Inflation in india is rising at an average of 7.7% per year and the interest rate we get out of a savings account is just 4 – 6%. Even in a fixed deposit account, we get return of 7-8% per year. Hence, we’re not making any profit, we’re effectively only retaining the purchasing power at some extent.

So if you think saving money is going to make us rich, think again. We will have to keep working until we die to just keep up with the daily expenses!

If you want to achieve financial freedom, start disciplined and consistent investing as early as possible then keep learning as you go.

Remember, things are never clear until it’s too late

-Peter Lynch