THE POWER OF COMPOUNDING
Most powerful forces of the universe
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“My wealth has come from a combination of living in America, some lucky genes, and compound interest.�
- WARREN BUFFET Email: Support@skillfinlearning.com
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What is Compounding? You go for an interview in a company. The HR gives you two options for your monthly take home pay. Option A
Get a fixed salary of $ 5000/- per month for the next 30 months .
Option B
Get $0.01 as salary in the first month. Then in each subsequent month the salary grows twice of the salary taken in the last month. Meaning your salary would be $0.01 in the first month, $0.02 in the second month, $0.04 in the third month and so on.
Take a minute to think? Which option will give you maximum benefit?
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Here is the answer Option A
• You get $5,000 per month for 30 months. In total you get $150,000 at the end of 30 months.
Option B
• In Option B, you would get a total salary of $ 10.7 million. • This is because of the magic of power of compounding.
• In this option, your salary doubles every month. ➢ For the first few months your salary is much less compared to option A. ➢ Your salary becomes almost equivalent to option A in the 20th month. ➢ After that because of compounding your salary keeps on increasing every month.
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Here is the answer
• The impact of compounding is less in earlier period and magnifies significantly in later period. • Since it is slow in earlier period it is not easy for people to realize its impact. This is the main reason why people are not able to hold their good investment for long period of time.
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“ Understanding both the power of compound interest and the difficulty of getting it is the heart and soul of understanding a lot of things‌.The Big money is not in the buying or selling, but in the waiting.â€? - Charlie Munger
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What determines Power of Compounding?
Power Of Compounding
Interest Rate
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Time Period
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Interest Rate – Example (1/2)
Fixed Deposit earning 5% per annum You have 3 investment options to invest $1,000
Mutual Fund earning 10% per annum Equity shares generating 12% per annum
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Interest Rate – Example (2/2)
Value of the investments
Time period (Years)
10
20
30
40
50
Fixed Deposit @ 5% per annum
$1,629
$2,653
$4,322
$7,040
$11,467
Mutual Fund @10% per annum
$2,594
$6,728
$17,449
$45,259
$117,391
Equity shares @ 12% per annum
$3,106
$9,646
$29,960
$93,051
$289,002
Even a small difference in interest rates can result in a large difference in values
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Time Period – Example
Time period (Years)
10
20
30
40
50
Equity shares @ 12% per annum
$3,106
$9,646
$29,960
$93,051
$289,002
Value of the investments
Taking the previous example, we see that the power of compounding is less in initial years, but amplifies significantly with increase in the number of years
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