Albert Einstein has called compound interest the eighth wonder of the world. And like other things, about compound interest too, he was not wrong. In his book “One Up On Wall Street”, legendary Fidelity fund manager Peter Lynch, narrates a story. About the native (Red) Indians of Manhattan, who way back in 1625 sold all their real estate to a group of immigrants for – get this – all of $24. Yes – real estate in Manhattan that is currently worth crores of rupees was sold for what in rupee terms is around Rs. 1,500!! And hence, ever since then, these Indians have been the subject of cruel jokes – but as it turns out that they may have made a better deal than the buyers who got the island. At 8% interest on $24 compounded over all those years, the Indians would have built up a net worth just short $30 trillion, while the latest tax records from the Borough of Manhattan show the real estate to be worth only $28.1 billion. Give Manhattan the benefit of doubt: That $28.1 billion is the assessed value, and for all anybody knows, it may be worth twice that on the open market. So, Manhattan’s worth $56.2 billion. Either way, the Indians could be ahead by $29 trillion and change.
This little story shows you the power of compounding and the points out the fact that the earlier you start investing the better it gets.
Let’s try and understand this through an example of two friends Ravi and Vishal. Both start working at the same time at the age of 23. Ravi starts saving when he turns 25 and invests Rs 50,000 every year. Assuming that on this he earns a return of 10% every year, at the end of ten years, Ravi has been able to accumulate Rs 8.77 lakh. After this, due to financial constraints he is not able to invest the Rs 50,000 every year. But at the same time he does not touch the money that he has already accumulated, hoping to live of it when he retires.
He lets the Rs 8.77 lakh grow and assuming that it continues to earn a return of 10% every year, he would have been able to accumulate around Rs 95 lakh by the time he turns 60. So the Rs 5 lakh (Rs 50,000 x 10 years) he had invested in the first ten years has grown to Rs 95 lakh. This even though he stopped investing (Rs 50,000 every year) after the first ten years.
Now let’s take the case of Vishal. During the first few years of his life Vishal enjoyed spending money on all kinds of things rather than invest regularly. At the age of 35, reality suddenly dawns on him and he starts investing Rs 50,000 every year. He invests this amount every year till he turns 60, i.e. for 25 years. Assuming he also earns a return of 10% per year on his investments. At the end Vishal would have managed to accumulate Rs 54.10 lakh.
Even after investing Rs 50,000 regularly for all of 25 years, Vishal has managed to accumulate Rs 54.10 lakh, which is around Rs 41 lakh less in comparison to Ravi. Now remember, Ravi has invested only Rs 5 lakh over the ten years he invested. In comparison, Vishal over the 25 years has invested Rs 12.5 lakh (Rs 50,000 x 25 years). Even by investing two and half times more than Ravi, Vishal has managed to build a corpus which is 43% less. This happened because Ravi started investing earlier. This allowed the money to compound for a greater period of time.
Also as the corpus grows, the impact of compounding is greater. Ravi as we know had managed to accumulate Rs 8.77 lakh after ten years and then he stopped investing Rs. 50,000 every year, allowing the accumulated corpus to compound for twenty years more. Let’s say, he had allowed the corpus to compound for only 20 years more till he turned 55. If the corpus had earned a return of 10% every year, then at the end Ravi would have accumulated a corpus of around Rs 59 lakh. By choosing to let his investment run for five years more, he managed to accumulate Rs 45 lakh more.
Now we know why Albert Einstein himself called the power of compounding the eighth wonder of the world. In this article we have given various examples of how potent this power is when combined with its ally --- Father Time. To grow your money is entirely up to you – the question is – Are you up to it?
The authors are leading financial advisors and may be contacted at firstname.lastname@example.org