When a person asked Warren Buffett for the single most powerful factor behind his investing success, and he had responded “Compound Interest”. Albert Einstein, one of the smartest men, said, “The most powerful force in the universe is compound interest”. He called it the “Eighth Wonder of the World”.
What is Compounding?
Compounding is a process in which your returns will increase exponentially over a long period of time. In compounding, the interest that you earn on your initial investment is reinvested with the principal amount. This means you can earn interest on both the principal amount as well as on your interest. Your initial investment remains fixed in simple interest, and your interest is not reinvested.
The power of compounding will help you to create an ample amount of wealth only if you have invested over a longer period of time, you can see the exponential growth in later periods. If you want to become a millionaire, you have to keep a horizon of at least 25-30 years.
We can earn 1.3 crores by investing 5000 per month for 25 years at an interest of 15% p.a. compounding annually. Mutual Funds like Axis Midcap has given 19.44% returns annually over the past 7 years. We can invest money in the stock market, mutual funds, loans, FD (fixed deposit) etc. These are the resources using that we can earn the money in the form of compound interest.
At which age we should start investing?
Sahil and Vijay are two persons who have started their career at 20 and plan to retire at 60. Sameer starts saving ₹5,000 every year from age 20 and continues to do so until he is 40 years old, after which he stops making any further investment. Sanjay, on the other hand, starts saving ₹40,000 every year from the age of 40 and continues to do so until he retires at the age of 60. If both earn, say, 12% per annum on their investments, which of them would be wealthier when they retire at 60? Sameer! Surprising, isn’t it? At 60, Sameer would have accumulated 34.75 lakh whereas Sanjay’s wealth would have been lower at 28.82 lakh.
The result would be the same even if one considers a one-time investment. For example, assume that Sameer invests ₹10,000 at the age of 20 in an instrument that fetches 15% per annum. Sanjay, on the other hand, invests
₹100,000 at the age of 40 in the same instrument. When both turns 60, Sameer’s ₹10,000 investment would have grown to ₹26.78 lakh, while Sanjay’s ₹1 lakh would have grown to only ₹16.37 lakh.
Thus, the longer you stay invested the more money you will make. The best way to take the benefit of compounding is to start saving and investing wisely as early as possible. The earlier you start investing, the greater the compounding power.
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