Compounding is basically is addition of interest amount in the principal amount. Compounding is such an instrument that it can make you rich in long way, don’t expect that I would say that it will make you rich over night.
Overnight successes are for movies only. But yes compounding is the thing will make you rich by doing nothing. There are lot of people like The Warren Buffet, Bill gates who compounded their money and today bill gates is such a legend that he left in job in Microsoft and decided to do donations now.
- How It Works
- Be Aware Of High Returns
- Key Factors To Consider While Compounding
- Inflation Rate
- How Much To Save
Here’s a very famous story about how compounding work which is something like;
Once upon a time there was a village. In that village there was rule of King Damodar who was fond of classic music. One day he was out to see his kingdom and suddenly he heard a very melodious voice which he enjoyed a lot, then he ordered his soldiers to bring that guy who so ever is singing so melodious.
Soldier took that singer to monastery. Soldiers introduced him in front of King who named ram. The ram start singing and King was listening him very quietly and carefully. When ram stopped, King was shocked that could anyone sing so well.
So after this King ask him to wish anything he wanted but ram said that sorry my lord but you cannot fulfill my wish. King said in anger there’s nothing which I couldn’t do you ask just.
Rama asked him to put a single rice grain in 1st box of chess and let it double every time nest box come and asked to give the grain which will come in 64 square.
King laughed and asks his ministers to do so. But when they start doing it their tension started as they even could reach the 64 square because they can’t calculate those big numbers and their stock of rick grain was already finishes in 20th square.
After all this King was full of anger but Ram defeated the King with the power of compounding and quietly leaves.
How It Works
Let now thoroughly understand what is the “Power Of Compounding”,
Assume that you have 1000 bucks in your saving account in April 1; you are getting 5% interest rate on it. So how much will you get in 10years? Let’s calculate:-
Interest amount credited in your account is 50 bucks. Now you will be getting interest on your 1050 bucks. 2nd year your interest amount will be 52.5 bucks.
And this will follow on like this. If you carried this for next eight years your account will look like: –
3rd year 1102.5 55.125 1157.125 4th year 1157.125 57.8 1215 5th year 1215 60.75 1275.75 6th year 1275.75 63.78 1340 7th year 1340 67 1506 8th year 1506 75 1582 9th year 1582 79 1661 10th year 1661 83 1744
After 10 yrs now your 1000 bucks are 1744 bucks. I know that it not sound much but now compare it with if you have invested 1000 bucks at a rate of 5% in your savings account for 10 years.
In simple interest you will get 50bucks each year credited to your account and as the interest rate is same for 10 years lets multiply and you will get an amount of 500 as interest amount.
Now you are getting 1500 as your principal amount after 10 years through simple interest. And 1744 as your principal amount after 10 years with compound interest. So we are getting 244 extra in same circumstances so why now to get compound interest.
While I know these figures must sound much but think of it when you have big balance in your account for long periods of time. As you must have heard a very popular proverb “More you put sugar in tea more it will get sweeten”. This same applies with compounding.
Be Aware Of High Returns
You have to especially of high returns because beginner always want to start compounding with the returns promising high returns but they act like a trap for you until and unless you are a very experienced in compounding.
Often investment promising high returns are highly risky because who is doing business professionally will always offer you moderate returns according to profit.
It is seen in future that there were many frauds happens all over the globe, they promise to give high return and in seek of high return people generally give money to them at last they ran away with all the globe and money got vanished.
But yes there are some techniques or some special circumstances where returns increases but they are realised by professionals only.
So take time to climb the ladder one by one step if you will step by skipping one or two steps you may fall or maybe you will climb to it but if by chance you fall from it then you going to lose your legs.
Key Factors To Consider Before Compounding
Let’s now figure out some basis you must concentrate on while compounding: –
It’s you goals which will make you decide how much interest rate you want. How much money you want to have today, tomorrow, in a year, in 5-10 years, in 30 years.
So choosing your goals is very important that will decide your further steps. What generally people made mistake is that they set their in a humorous way. Which they themselves believe that they can’t achieve so what’s o these types of goals.
Choose some realistic goal which you think and which you can achieve.
- Time: –
After making goals time is the thing you have to decide for your investment. Because the time of investment you choose will shortlist the investment options for you.
As per some guidelines which I follow is that if we want to invest for more than 10 years then you must go with stock market and mutual funds, but if you are investing for less than 10 years then you must invest through bank, PPF etc.
For achieving short term goals your money should be given to bank as they provide good returns in short whereas stock market not.
But in long term stock market can give you a good amount in interest.
- Returns: –
Now return is also a big factor if you don’t want to modify your money but still want to invest you may go with some safer options like bank.
But if you want to multiply your money then you must go with stocks and mutual funds because bank provides interest rate of 5%-9% and that’s maximum.
But when it comes to stock it gives you returns which is not measurable they might be negative sometimes but generally stocks provides interest rate higher than 10% that’s the minimum interest rate in general.
That’s the factor which many of the people will ignore while compounding. They assumed that 5% interest rate but people generally ignore the inflation rate in country.
For you who don’t know about inflation rate then inflation rate refers to average of price increasing. For example let’s assume that last year inflation rate was 5%. Then if you would have buyed a biscuit last year at 1 buck then now you will get that same biscuit at 1.05 bucks.
If you will research a little bit then inflation rate in India was as follow:-
2018 – 4.86% 2017 – 2.49% 2016 – 4.94% 2015 – 5.87% 2014 – 6.35% 2013 – 10.91% 2012 – 9.31% 2011 – 8.86% 2010 – 11.99% 2009 – 10.88% 2008 - 8.35%
So if you calculate then average inflation rate of last 5 year was 4.9%.
And average inflation rate for last 10 year was 7.71%
Price level is increasing on a rate of 4.9% and you are getting 5% interest it mean that the value of your money didn’t increased but yes it’s not depreciated too.
How Much To Save
Now you will be wondering that know you are aware to invest how to invest but how much should I save or say invest. What I have learnt and what if follow is that we should at least save 10% of our income in starting and with time you must increase your savings from 10% to 30%.
According to me following some big investment tycoon I learnt that we should spend 40% to accomplish needs, 30% in wants, and last 30% should be used for compounding.
Still you want me to say something, no I don’t have to just go and start investing with compounding as soon as possible don’t worry about time everybody have time it just you have to manage it .
And if you don’t have then you have to make time because it’s about future, about your retirement, your family goals, for vacations, and to enjoy your life too. It’s never too late.
“Better late than never”