It took only two people–Adam and Eve–to lead to a population of an estimated 8.9 billion humans. When the offspring are productive, the multiplier effect clearly yields amazing results. Time and consistency, therefore, can turn mission impossible into a cakewalk.
In much the same way as the global population has multiplied over the ages, the multiplier effect also applies to money. I am sure we’ve all learnt simple interest and compound interest formulae in school. Still, it needed Albert Einstein to re-emphasise their impact in our lives. The eminent scientist once said, “Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.”
Compounding in action
Let’s consider one scenario where I borrow. For example, if I take a loan of INR1,00,00,000 (10 million) for 20 years at an annual interest of 8 percent, I will have to pay an equated monthly installment (EMI) of INR83,644 per month for the next 240 months (20 years X 12 months).
In total, I will be repaying more than double the loan amount to the lender — a total of INR2,00,74,562, or over INR20 million . This happens when I do not understand the geometrical power of compounding.
Allow me to present a second scenario, where I invest. If I was to invest, for example, a sum of INR35,280 or only 42 percent of the EMI amount–that I had mentioned in the first scenario–for the same 240 months, and at the same 8 percent interest, the total sum it will amount to will be INR2,00,74,562 or over INR20 million.
I am sure you can tell the huge difference in outcomes across both scenarios. This is the eighth wonder of the world that can only be experienced firsthand. I suggest you read the above paragraph one more time to fully grasp the concept and to understand the massive difference between borrowing and investing. In a gist, this is how compound interest works.
Simple interest, meanwhile, is when the return is paid out to the investor on an annual basis, so that he or she can use it as they please. In this case, the invested amount remains constant. In compound interest, the previous year’s interest component is added to the principal. This way, it increases the total investment amount for the forthcoming year. This snowball effect goes on for years and decades until one chooses to hold off or repurpose the funds.
Future value of money
Our grandparents often talked about receiving INR0.10 as their pocket money when they attended school. They are implying that the present value of the rupee has lost so much value that even an INR100 note is insufficient today. Our wallets are losing value with each passing moment.
Interestingly, an unintended outcome of India’s 2016 demonetisation drive was the unearthing of large amounts of money from almirahs, books, purses and boxes. These monies would otherwise have only reduced in value over the decades. And eventually, they’d be as valuable–or valueless–as INR0.10 is today.
Loan and inflation versus investment
Even if we stay away from taking a loan and save ourselves from the effects of compounding, inflation will loom large over our earnings. This inevitable phenomenon will consistently erode the purchasing power of our money — a negative impact of compounding.
To slay both demons, our only saviour is investments, especially ones that can generate a higher return relative to inflation.
Consider Harish’s example. He invested INR1,00,000 in 2001 at 12 percent to withdraw INR9,64,000 in 2021, after a span of 20 years. Ramesh started his investment a year later, in 2002, with an investment of INR1,00,000 in 2002. He withdrew INR8,61,000 in 2021. Only a year’s delay reduced the final value by INR1,30,000.
What I am trying to highlight here is that Ramesh effectively lost out on a sum, simply due to a year’s delay, that was larger than his original investment amount. The power of compounding is, therefore, evident here.
Meanwhile, Satish invested INR1,00,000 in 2001 at 10 percent. He withdrew INR6,72,000 in 2021. His returns represented a reduction of 200 basis points (100 basis points is equal to 1 percent) and reduced the final value by INR2,92,000.
Focus on longevity and the interest rate
We only need to focus on a few key aspects to win the race against inflation and befriend compounding — namely, longevity and interest rate.
Longevity will require us to stay invested for a longer duration and also to be in the pink of health to enjoy the wealth. It is no surprise that our physical wellbeing can also utilise the concept of compounding by exercising regularly. In Tony Robbins’ book called the 5 am Club, he speaks about the 20/20/20 formulae, where he casts the spotlight on an individual’s physical wellbeing.
Interest rate, meanwhile, is determined by the investment vehicle we park our funds in. Making a fine balance between risk and return is imperative here.
The simplest analogy that come to mind is that of sowing seeds to grow more trees. In due course, a handful of apple seeds that one sowed can yield a full blown apple orchard.