Hi all, thanks for visiting this blog. Today we talk about Compounding, it is perhaps most interesting topic in finance, the first day you understand power of compounding you will be immersed into it and probably miss your sleep.
As mentioned in above quote, it is very important to understand compounding. Lets see its power through an example:
If I give you two options which one would you choose?
A. Rs 10,00,000 today
B. 1 paisa today and doubled daily for 1 month.
You chose option A. , why the hell would anyone want 1 paisa even if it is doubled daily right, well no........... option B would give you 1paisa on day1, 2paisa on day 2, 4paisa on day 3..... skipping to end of month you will get mind blowing return of Rs. 53,68,709.12 on 30th day. So how did 1 paisa, which is not even in circulation grow to 53lacs in just one month. This is because it had a special power, 'Power of Compounding'. Want to know more about power of compounding......... read on.
Ever played any car racing game? Than you must know about Nitro boost, which immediately speeds up your car and gets you ahead of others. Similarly compounding has two boosters one is effective interest rate other is time. The more the value of these two the more will be power of compounding and greater will be your returns. In the question above the interest rate was exuberantly high at 100% per day which is hypothetical. However these days you will manage to get 9% p.a rate on FD's. If you invest Rs 100 today, at 9% per annum you will get Rs. 236 after 10 years, at 18% per annum you will get Rs. 523 after 10 year, doubling the interest rate more than doubles your returns. So choose higher rates.
Quiz Time:
Which one would you choose?
A. Bank of People offering you rate of 12.5% compounded per annum.
B. Bank of People offering you rate of 12.0% compounded per month.
Does plainly choosing highest interest rates guarantee you maximum returns. You have to look more closely at second Rate. 12% compounded per month means that you will be getting 1% rate every month. If you invested Rs 100 at beginning of year you will get Rs. 101 by end of first month, this amount will than be reinvested for another month at 1% giving you 102.01 in second month. If you continue this process you will get Rs. 112.68, while if you had invested in option A. you would get only Rs. 112.50. So clearly option B is better. In this case we convert rate to Effective Rate, which is just rate per annum, here it is 12.68% pa in option B while it is same at 12.50% in option A.
 |
| Effect of Compounding for various frequencies |
Time is the other booster. Over long periods, interest earned through compounding can be much higher than the principle invested. If you were a smart kid and planned early to become very rich and you invested Rs. 1,00,000 at age of 10 in a portfolio yielding 13.25% per annum and forgot it for 50 years, by your retirement i.e. when you will be sixty you will have a portfolio of more than Rs. 5,00,00,000 (approx. 1 million $). Pretty easy to become a millionaire. You just need generous parents who are willing to give you initial amount. Just wait for 56 more years and you will be able to gift your grand grand son a billion dollars from just the initial Rs. 1,00,000 given by your parents, though you might not survive that long. I am sure your grand grand son would always love you for that.
Well certainly there are not many kids who will invest at that age, also you will not become a millionaire investing Rs. 1lac at the age of thirty. Buy there are certainly other options through which you can become a millionaire. But compounding needs time, so if you think you want to be rich early in life than you have to start investing early. Regularly investing is best way to grow your money, to show this consider yourself 25 years old. You have a decent paying job, and one fine day you read somewhere that one must invest regularly. You think its the same old cliché however this time you consider to act on it. You start by investing some portion of your monthly income say Rs.5000 in portfolio giving you 11% return(compounded monthly or 11.57% annual rate). Invest Rs. 5000 per month for first year and since your salary increases every year, you increase investment amount by 8% every subsequent year i.e. 5000 per month for first year, 5400 p.m. for second year and so on. After 35 years you will cumulate Rs 5.6 cr.(1 million $).
This is why we must know about power of compounding, it can help you multiply your wealth. Scope of compounding is much wider than explained here. Compounding also works in Network marketing or MLM business etc.
P.S. I am certainly not going to pay you anything for any of the options you selected.
No comments:
Post a Comment