Albert Einstein, the famous scientist, had once said, "There are seven wonders in the world, the eighth is compounding. He who understands it, earns it, he who doesn't, pays it." So what was it that prompted one of the best human minds to opine on those lines?
Let's consider the historical example of the Native Americans who sold the island of Manhattan -one of the most expensive pieces of real estate in the US -for beads and trinkets worth $24 in 1626 to a group of Pilgrims. Today, had they not sold the island, they would be worth around $8 trillion. That's a big sum of money. Was selling the island a mistake? Most would agree.
What if the Native Americans had invested the amount in an account yielding 8% compounded annual interest? They would have $223 trillion today , enough to buy 28 Manhattans. Even at lower interest rates, they still would have come out ahead. There are 5 important rules to make compounding work for you:
1) Start early:
The younger you start, the more time compounding has to work in your favour, and the wealthier you can become. The next best thing to starting early if you already haven't is starting now.
Riya and Priya, two friends, started their career together at 25. Riya started saving Rs 5,000 every month from her salary , giving her a 9% return per an num and continued till she was 35. Later, she had some financial difficulties and couldn't save further. However, she did not withdraw what she had saved and the investment continued to earn her 9% per annum -compounding.
Priya, on the other hand, thought she was too young to save and started saving only at 35 as she realized that she has been working for 10 years without any savings. She, too, started saving Rs 5,000 every month till her retirement at 60.
Riya saved Rs 6 lakh in 10 years and Priya saved Rs 15 lakh in 25 years. Even though Priya saved 2.5 times more than Riya had saved, her corpus at age 60 was Rs 56.47 lakh and Riya, who saved only for 10 years, had a corpus of Rs 84 lakh. This could only happen because Riya started saving early and she let the magic of compounding earn money on her money .
2) Invest regularly:
Don't be haphazard. Remain disciplined and make savings for retirement a priority . Do whatever it takes to maximize your contributions. If Riya had continued to invest till 60 instead of stopping at 35, she would have had Rs 1.48 crore.
3) Be patient:
Do not touch the money unless really needed. Compounding only works if you allow your investment to grow. The results will seem slow at first, but persevere. Most of the magic of compounding returns comes towards the end.
4) Invest for optimum returns:
Invest your money according to your risk tolerance and time frame of investment. Don't put your money in what you feel is a convenient option as every 1% return makes a big difference to compounding.
Let's suppose Rs 5,000 is invested each month in two instruments, one giving 9% and the other 11% returns annually. In the long run, a small difference of 2% in return could almost double the maturity value (see table Small Difference, Big Returns).
5) Mind inflation & taxes:
We have seen here how compounding can multiply money many fold when you are investing. Similarly, it can work against you when you are borrowing money or you are investing for negative real returns, that is when your post tax return is less than inflation. These things can make a substantial difference
In the next few weeks, the following topics will be covered over several episodes: senior students joining workspace, young working professionals, single working professionals (female) and married professionals without children. If you belong to any of these groups and have queries related to financial planning, you could post them on http:www.indiainvestkaro.com and some of the most relevant ones would be answered by experts and professionals from the field.
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