Albert Einstein is reported to have said that “Compound Interest is the eighth wonder of the world, he who understands it earns it and he who does not understand it, pays it”
Whether Einstein has actually said this or not, the statement is still a profoundly powerful one for those who aspire to make enormous wealth.
As per Investopedia - Compound interest is interest calculated on the initial principal, which also includes all of the accumulated interest from previous periods. In other words, Compound Interest can be defined as “interest on interest”, which makes the original sum grow at a rate much faster than the “simple interest” which is calculated only on the original principal amount.
The formula of compound interest is : A=P(1+r)n
In this formula - A is the Amount (Original investment plus interest earnings over a period of time), P is the original Principal investment, r is the Rate of Interest and n is the period. One need not be a rocket scientist to understand and appreciate that in the above formula, n is the exponential factor, the key component that adds value to the equation.
To build enormous wealth, it is important to understand and harness the power of compounding. It is important for an investor to understand that being invested in the market and spending more time in the market with the amount invested in it is essential to create wealth.
Most of us have seen a graph of how Warren Buffet’s (the world’s most successful investor) wealth has grown.
One can see the gradual growth of Mr Buffet’s wealth in the later part of his life. His initial investments have been accumulating at a slow but steady phase. After his age of 52 his wealth starts increasing at an astonishing rate. 620Mn at age 53, 1400 Mn at age 56, 2300 Mn at age 58, 3800 Mn at age 59, 17000 Mn at age 66 and so on.
The caption in the picture mentions that 99% of his wealth was earned after his 50th birthday. The secret of this growth after the age of 50 is undeniably the first portion of the time scale – i.e. the period between the age 14 to 50. These 36 years laid the foundation.
If we replace the components in the Compound interest formula with the figures from Warren Buffet graph, the thing that stands out is the “N” factor.
Is it possible for a middle class or a lower middle class Indian with a disciplined approach for regular investment to aspire for wealth like this? Can a middle class Indian exploit the power of N?
I would like to give an example of a friend who wants to set aside an amount of Rs 1,000/- per month, for his just born child. The goal is to build a corpus for the child’s retirement (at the age of 58 of the child)! He wants to invest Rs 1,000/- per month, growing the investment at 10% per year for the next 25 years. At the end of 25 years what ever is the enhanced monthly investment, his child will start contributing that much amount on monthly basis WITHOUT any further enhancement till the child’s age of 58. In other words the father will start with Rs 1,000 per month today, increase it to Rs 1,100/- per month at the 13th month, Rs 1,210/- per month at the 25th month, and so on till the 300th month (25 years) when the monthly investment would become 10,835/-. At this point, his child will start investing 10,835/- per month and would be continuing with this investment pattern WITHOUT any further increments, till his age of 58.
Between father and child, they would have over the period of 58 years set aside (month on month) Rs 54.70 Lakhs Principal. And at the age of 58 of the child the amount, @ 8 % compounded per annum, would have become Rs 5,14.04 Lakhs.
For investors who would prefer equity markets the corpus would become Rs
14,73.29 Lakhs @ 11% compounded per annum and Rs 40,19.55 Lakhs @ 13.68%
compounded per annum.
(As per Investopedia - the average annual return of the The S&P 500 Index since its inception in 1926 through 2018 is approximately 10% –11%.
As per Economic Times - the Sensex has generated an annual return of 13.68% since its launch in 1986.)
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