Thursday, June 16, 2016

Friday, January 16, 2015

Idea No 6 : Compounding is one the greatest social Innovation that is still not understood

Compound interest is often called the eighth wonder of the world, because it seems to possess magical powers, like turning a few rupees  into millions 

The great part about compound interest is that it helps us to achieve our financial goals, such as becoming a millionaire, retiring comfortably, or being financially independent

There is a classic story  of a kid who was asked a trick question "Would you rather have $10,000 per day for 30 days or a penny that doubled in value every day for 30 days?" 

Today, we know to choose the doubling penny, because at the end of 30 days, we'd have about $5 million versus the $300,000 we'd have if we chose $10,000 per day" . This is power of compounding a social innovation which encourages savers to invest  and entrepreneurs to build business model that is self compounding through  brands , Network effects etc

Compound interest can be calculated using the following formula:

FV = PV (1 + i)^N
FV = Future Value (the amount you will have in the future)
PV = Present Value (the amount you have today)
i = Interest (your rate of return or interest rate earned)
N = Number of Years (the length of time you invest)

TIP: A simple way to know the time it takes for money to double is to use the rule of 72. For example, if you wanted to know how many years it would take for an investment earning  compound interest of 12% to double, simply divide 72 by 12, and the answer would be approximately six years. The reverse is also true. If you wanted to know what compound interest rate you would have to earn to double your money in five years, then divide 72 by five, and the answer is about 15%.

One of the key concepts about compounding is this: The earlier you start, the better off you'll be. 

Let's consider the case of two other investors, Luke and Walt, who'd also like to become crorepati 
Say Ram put Rs 20,000 per year into the market between the ages of 24 and 30, that he earned a 12% aftertax return, and that he continued to earn 12% per year until he retired at age 65. 

Rohan also put in Rs 20,000 per year, earned the same return, but waited until he was 30 to start and continued to invest Rs 20,000 per year until he retired at age 65. In the end, both would end up with about Rs 1 Crore. However, Ram had to invest only Rs 120,000 (i.e., Rs 20,000 for six years), while Rohan had to invest Rs 720,000 (Rs 20,000 for 36 years) or six times the amount that Ram invested, just for waiting only six years to start investing.

Clearly, investing early can be at least as important as the actual amount invested over a lifetime. Therefore, to truly benefit from the magic of compounding, it's important to start investing early.  After all, it's not just how much money you start with that counts, it's also how much time you allow that money to work for you.. Gains beget gains, which beget even larger gains. This is again the magic of compound interest.

In addition to the amount you invest and an early start, the rate of return you earn from investing is also crucial. The higher the rate, the more money you'll have later. Let's assume that Ram from our previous example had two sisters who, at age 24, also began saving Rs 20,000 a year for six years. But unlike Ram , who earned 12%, his one sister earned only 8%, while another sister  did not make good investment decisions and earned only 4%. When they all retired at age 65, Ram would have Rs10749680, first Sister would have Rs 25,30,250, and his youngest sister  would have only Rs 5,66,200. Even though Ram  earned only 8 percentage points more per year on his investments, or Rs 1600 per year more on the initial Rs20,000 investment, he would end up with about 20 times more money than his younger sister .Clearly, a few percentage points in investment returns or interest rates can mean a huge difference in your future wealth.

Therefore, while stocks may be a riskier investment in the short run, in the long run on account of higher return they make great sense for wealth building .