If you are thinking of planting a money tree and expect it to make you money, it is better in imagination than in reality. But is there something that can grow your money? The compounding effect can explain this for you.
In an era where trading has captured the higher interest of investors, it reveals their enthusiasm and interest in making quick money. While the stock market itself is a high-risk market, trading is much riskier than it. You could even call it a gambling act where, in the urge to make enormous money, the loss is disregarded to an extent where the entire capital is wiped out. Well, it also isn’t a denial that you can make quick money through it.
If you want to multiply money, quick schemes need to be ruled out, as everything comes with time and patience is the key. If you truly believe in this motive, you’ll find compounding as the real kicker. This isn’t just coming from us; the scientist Albert Einstein said that compounding is the eighth wonder of the world, and he had his math to back it. He quotes, “He who understands it, earns it; he who doesn’t, pays it.”
Warren Buffett is a living example who credits his success as a great investor to the power of compounding.
So are you in for growing money? Let’s help you understand the concept of compound interest more intriguingly.
The Tale of an English Settler in Australia and the Rabbits
Thomas Austin, in 1859, decided to import 24 rabbits from England. While we normally import something costlier, the man here imported rabbits to Australia. The astonishing thing was that these 24 rabbits multiplied to overrun Austin’s property. Can you imagine rabbits all over his land? It stinks, but yes, they were everywhere on his property. This happened over a couple of years, and of course not overnight.
The truth is that Australia had never seen rabbits until then, and neither did the predators recognize them as prey. Without much resistance, the rabbits multiplied. In a year, the rabbit population increased by 35%. In 5 years there were 108 of them, in 20 years 9,500 of them, and in 35 years 900,000 of them.
So how about 45 years? There were 17.5 million of them, and by the 66th year, Australia had become home to nearly 10 billion rabbits. Imagine the situation for other animals that suddenly had to adapt to living among such an overwhelming population.
What just happened?
The story wasn’t just about seeing a large number of rabbits, but about understanding the effect of compounding. There are two lessons here. First, growth multiplies over the years. Second, since he imported the rabbits in 1859, 66 years later the 20th-century generation in 1925 witnessed the population reaching billions. Had he done it earlier, perhaps even the 19th-century generation could have seen that scale.
This is proof that compounding turns a small beginning into something massive. You need to give it time to grow, and you need to start early to reach the desired outcome.
So hasn’t making money become easier with this idea? After all, this example was about rabbits. For money to multiply, however, you also need patience and consistency.
Let’s get real.
Suppose you are 25 years old and want to become a crorepati in the next 25 years, by the time you reach the age of 50. Let’s see how that is achievable through compounding.
To reach your goal of ₹1 crore in 25 years, the initial capital must be at least ₹6,00,000, assuming your investment generates a return of 12%.
Here is the formula to calculate the maturity value after 25 years:
Amount = Principal × (1 + Interest / 100) ^ Time
= 600000 × (1 + 12/100) * 25 = Rs 1, 02, 00,038
You’ll receive ₹1 crore, ₹2 lakh, and ₹38.
This happens due to reinvesting the interest earned back into the principal multiple times until maturity. Assuming in this context that you bought Tata Motors stock, you must be disciplined enough to ignore the 12% dividends that come into your account and reinvest that dividend amount to buy more Tata Motors shares.
Of course, the profit you make is much greater when you hold 100 shares compared to holding just one share. So by reinvesting the interest amount, you are essentially buying more Tata Motors shares.
Let’s break this down to understand the minute details.
| Principal | Interest (12%) | Compound Interest | Accumulated amount | Year |
|---|---|---|---|---|
| 600000 | 72,000 | 0 | 672000 | 1 |
| 600000 | 72,000 | 80,640 | 752,640 | 2 |
| 600000 | 72,000 | 90,317 | 842,957 | 3 |
| 600000 | 72,000 | 101,155 | 944,112 | 4 |
| 600000 | 72,000 | 113,293 | 1,057,405 | 5 |
| 600000 | 72,000 | 126,889 | 1,184,294 | 6 |
| 600000 | 72,000 | 142,115 | 1,326,409 | 7 |
| 600000 | 72,000 | 159,169 | 1,485,578 | 8 |
| 600000 | 72,000 | 178,269 | 1,663,847 | 9 |
| 600000 | 72,000 | 199,662 | 1,863,509 | 10 |
| 600000 | 72,000 | 223,621 | 2,087,130 | 11 |
| 600000 | 72,000 | 250,456 | 2,337,586 | 12 |
| 600000 | 72,000 | 280,510 | 2,618,096 | 13 |
| 600000 | 72,000 | 314,172 | 2,932,267 | 14 |
| 600000 | 72,000 | 351,872 | 3,284,139 | 15 |
| 600000 | 72,000 | 394,097 | 3,678,236 | 16 |
| 600000 | 72,000 | 441,388 | 4,119,625 | 17 |
| 600000 | 72,000 | 494,355 | 4,613,979 | 18 |
| 600000 | 72,000 | 553,678 | 5,167,657 | 19 |
| 600000 | 72,000 | 620,119 | 5,787,776 | 20 |
| 600000 | 72,000 | 694,533 | 6,482,309 | 21 |
| 600000 | 72,000 | 777,877 | 7,260,186 | 22 |
| 600000 | 72,000 | 871,222 | 8,131,408 | 23 |
| 600000 | 72,000 | 975,769 | 9,107,177 | 24 |
| 600000 | 72,000 | 1,092,861 | 10,200,039 | 25 |
So, are you happy to finally be a crorepati in 25 years? If you could wait for another 5 years, the compounded amount you would receive is ₹1,79,75,953. That is a difference of ₹77,75,915 in just 5 years.
| Principal | Interest (12%) | Compound Interest | Accumulated amount | Year |
|---|---|---|---|---|
| 600000 | 72,000 | 1,092,861 | 10,200,039 | 25 |
| 600000 | 72,000 | 1,224,005 | 11,424,043 | 26 |
| 600000 | 72,000 | 1,370,885 | 12,794,928 | 27 |
| 600000 | 72,000 | 1,535,391 | 14,330,320 | 28 |
| 600000 | 72,000 | 1,719,638 | 16,049,958 | 29 |
| 600000 | 72,000 | 1,925,995 | 17,975,953 | 30 |
That is, if you had invested 5 years earlier, at the age of 20, you could have still received this amount by the age of 50. So the longer you let it compound, the more money it makes, and the earlier you invest, the sooner you can accumulate more wealth.
Now do you understand how rabbits in Australia multiplied, and how your money can too?
Key points to remember
- The compounding changes with the compounding rate and the number of times it is compounded.
For instance, ₹6,00,000 compounded for 2 years at 12% is different from being compounded at 15%.
| Principal | Interest | Years | Amount |
|---|---|---|---|
| 600000 | 12% | 2 | 752640 |
| 600000 | 15% | 2 | 793500 |
So, the higher the return, the greater the compounding.
The number of times refers to how often the interest is compounded. It can be monthly, quarterly, semi-annually, or yearly. This factor can significantly change the amount you receive.
| Principal | Interest | Years | Number of times | Amount |
|---|---|---|---|---|
| 600000 | 15% | 2 | Yearly | 793500 |
| 600000 | 15% | 2 | Semi-annually | 801281.5 |
| 600000 | 15% | 2 | Quarterly | 805482.5 |
| 600000 | 15% | 2 | Monthly | 808410.6 |
In this case, the more frequently it is compounded, the greater the returns.
To calculate monthly, quarterly, or semi-annual compounding, you can use this formula.
A = P ×(1+i/n)^(n×t)
A is the amount P is the principal i is the interest n is the number of times
For annually, n = 1 For semiannually, n = 2 For quarterly, n = 4 For monthly, n = 12
- Compounding takes place over time and you have to give it a nice time.
Otherwise, everything appears smaller.
| Principal | Interest | Years | Amount |
|---|---|---|---|
| 600000 | 15% | 10 | 2427335 |
| 600000 | 15% | 20 | 9819922 |
So time carries the weight of doubling the amount. Patiently wait for it to multiply your money, or be ready to settle for less.
- The earlier, the better to enjoy the money.
Now that you know how compounding works, would you start late or get on it early? Because what’s the point of saving a huge corpus when you are old and can’t truly enjoy the money?
| Principal | Interest | Start Year | End Year | Amount by the End |
|---|---|---|---|---|
| 600000 | 15% | Age of 20 | Age of 50 | 3, 97, 27,063.17 |
| 600000 | 15% | Age of 30 | Age of 50 | 98, 19,922.43 |
There is a difference of ₹2,99,07,140.73 that you would be missing if you start late. To accumulate this amount, shouldn’t you start early?
- Staying patient during the entire process
If you don’t, you’ll end up following a strategy that requires constant entry and exit planning. Timing the market is difficult and can lead to losses, whereas keeping your money invested and undisturbed is when the real work happens.
- While compounding is powerful, SIPs are much safer during uncertainties
The effect of compounding can be implemented in any investment, but SIP investments are allowed only in certain instruments, and smallcase investing is one among them.
The SIP option allows an investor to invest regularly by choosing to invest a fixed amount of money every week, fortnightly, monthly, or quarterly. The general preference among investors has been monthly. So let’s see how monthly investment helps in compounding.
Suppose you are making a small investment through an SIP option of ₹5,000 per month, with an average return of 12% for 10 years, versus a lump sum investment of ₹6,00,000. Let’s understand what the receivable amount would be.
| Principal | Interest | Years | Amount |
|---|---|---|---|
| 5000 monthly | 12% | 10 | 11, 61,695 |
| 6, 00,000 lump sum | 12% | 10 | 18, 63,509 |
The formula for monthly investment compounding formula is A = P×[{(1+i)^(n-1)}/i] × (1+i)
A is the amount P is the principal n is the number of times i is the interest
You can see that monthly SIP smallcase investing gives a lesser return compared to a lump sum investment. SIPs usually average the buying price of the holding by consistently purchasing shares at different prices.
This way, during a market downturn, monthly SIPs protect you, while a lump sum investment may leave you at a loss, even though lump sum investments may look attractive during a bullish market.
Are you set on being rich?
The higher return is not the thing to chase in investing; rather, it is consistent returns that matter, so you can continue earning steadily and double your money over time. Just as India’s development did not happen overnight but took years, so will your journey towards becoming rich.
While the compounding effect is powerful, the type of investment on which you implement it matters too. Why is that? An FD can be a good environment for compounding, but the returns are lower. If you are willing to take a little risk for an average return of around 12% from the stock market, smallcase investing can help you achieve it.
If you are wondering how to start with a smallcase investment right now, head to GreenPortfolio. We will create customized smallcases based on your goals.
So compounding isn’t as hard as it once seemed, is it? Get your interest to work harder to earn more interest. Let this be the time when your money works harder than you do for money.
Keep investing!
