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How can Einstein make you rich?

Here's what Albert Einstein had to say about Compounding of Capital: "Compounding is mankind's greatest invention because it allows for the reliable, systematic accumulation of wealth." He called it the 8th wonder of the world. So, we ask you, have you made the smartest decision with your money to avail of compounding of capital?

Watch the video

What is Compounding?
How does Compounding work?
I am not convinced about starting early - show me an illustrative example
So what should I be doing to benefit from Compounding?

1. Start early
2. Invest regularly
3. Leave your money uninterrupted
4. Be patient
5. Don't be distracted

What is Compounding?

Here is a quick recap. We know you might remember this from your class 5 maths lesson, but just in case, here is an example:

Lets say you invest Rs 100 and at the end of the first year you earn a compound interest of 8%, i.e., Rs 8. At the start of the second year, you have Rs 108. The total interest will now be earned on this Rs 108 amount, and not just the original Rs 100 amount. At the end of year two your money earns an interest of Rs 8.64. Notice, the extra 64 paisa you get. Its because you are getting interest on the Rs 8 interest you earned in the first year. The graph below shows the impact of Compound Interest vs. Simple Interest. Notice that by taking advantage of Compounding you could end up with almost double the amount of money than without Compounding.

How does Compounding work?

Well, the trick is to start early even if one starts with a small amount so that one can benefit from the long-term compounding of capital. The longer you let your money compound, the higher the pool of capital that you will have in the future. It's not important that you start with a very large amount of money. In fact, it's more important that you start early.

I am not convinced about starting early - show me an illustrative example

Raj and Rita are twins, but see the world of investing very differently. Here is what they did:

Rita: Starting age 25, invested Rs 2 lakhs per annum for 10 years and then stopped

Raj: Starting age 35, invested Rs 2 lakhs per annum for 30 years till he turned 65

Who do you think created more wealth when the twins turned 65 years of age, assuming both earn an 8% rate of return on their investments?

Even though Raj invested three times the amount of money as Rita did, Rita ends up creating more wealth. Since Rita started early, her portfolio could benefit from compounding of capital for a longer period of time and thus ended up being much bigger. This is the magic of compounding.

The lesson for all of us is to start early, even if we start with a small amount.

So what should I be doing to benefit from Compounding?

For starters, recognize that you don't have to be rich to invest. In fact, you can become very rich just by starting with a very small pool of capital and letting it compound over a long period of time.

Here is a practical list of action steps that can help you benefit from Compounding of capital:

1. Start early: even if you start with a small amount of capital.
2. Invest regularly: consider investing through Systematic Investment Plans (SIPs).
3. Leave your money uninterrupted: don't disturb the process of compounding.
4. Be patient: by definition, Compounding works only over long periods of time.
5. Don't be distracted: don't let ups and downs in the markets distract you.

Comments

Thanks for your comment

    

Raj said : 22/04/2010	I was reading your note on compounding and how SIP will help acheive it. I fail to understand how non dividend based SIP will help compound as the returns are based on NAV and not on a guaranteed interest rate?
Kamal Deep Sanan said : 07/05/2009	A very educative article.
Anuj Guglani said : 05/05/2009	An Eye Opener!