Compounding the investments may reap benefits in the long term as the formula of compound interest plays its magic.

Growing up, I always waited for birthdays and festivals. I would really hope for some ‘CASH’ raining during the day. (You know how parents and relatives give you a few notes in an envelope on special occasions).

I would dream of spending it on chocolates, cotton candy, ice-creams but usually, my mom would take me out of my Walter Mitty moment. She would always take my hard-earned money (definite pun intended) and say that she was going to add an equal amount to it and put the entire thing into the bank. 

A younger me gave in for the excitement of having that extra money. But as I grew older and saw my friends spend all their money, I would always contend her idea of savings telling her that we can still save later.

While my mom would anyways have her way, she would use her favorite line to justify “Abhi se save karo, Paise se hi Paisa banta hai.” (You should start saving from now as money makes money)

Trust me I didn’t really understand the meaning then and would always be angry on her for her being so strict with me. 

My mom passed away when I turned 17, and this habit of putting everything into the bank ended there.

This how I understood the true meaning of Compound Interest and the power of compounding

When I was started studying for CA degree, I didn’t really want to ask my dad to fund my tuition. I wanted to work for a year before pursuing my degree. During this conversation, he handed me a passbook saying you already have the money. Scrolling through the pages of the passbook, I had tears in my eyes.

And that day I  practically understood “THE POWER OF COMPOUNDING”

In financial terms, Compound interest simply means that instead of taking out any earnings you make from interest, you leave it invested, earning interest on interest.

But if you would study its impact carefully, you would realize that this simple math formula was instrumental in the development of modern Civilization. So here is the magical formula of compound interest

 P (1 + r/n)^(nt)

The origin of interest goes way before the development of money. Loans of seeds and animals were likely the earliest forms of interest. The borrower returned the seeds with a share of harvest or animals with their progeny. The development of money just meant the exchange of another item of value. As Civilization progressed, so did the process of charging interest. But the core remains the same even in modern times.

People have revered this concept of Compound interest since time immemorial. Albert Einstein went on to call the concept of Compound interest as the 8th wonder of the world.

He who understands it, earns it; who doesn’t, pays it

Albert Einstein

Who hasn’t heard about The Oracle of Ohama, Warren Buffet? He over his 52-year stint as CEO of Berkshire Hathaway has earned nearly 2 million percent return on his investors’ money which means. To put it into perspective, “If you invested $10,000 into Berkshire Hathaway in 1965, that investment would be worth $88 million today“. This man always re-iterated the importance of Compound Interest in his life & business.

My wealth has come from a combination of living in America, some lucky genes, and COMPOUND INTEREST

Warren Buffet

While compound interest has been colloquially used in reference to personal investment strategies only, companies also use this formula as a tool for the following:

Generating Profits for shareholders:

Shareholders expect dividends as a return on their investment. But instead, if these dividends are compounded, and reinvested in the business, higher dividends may be payable the next year. Compound interest work as a return multiplier. Each passing year, the interest that investors receive grows because they earn interest on interest

Pension/ Provident Fund Payments:

Every year, employers deduct a fixed portion of your salary as your retiral benefit. This money is invested in financial instruments that pay guaranteed return rates. The returns are re-invested and by the time a person retires, he gets a lump sum amount (much more than invested).

The magic of compound interest works when you start investing at the right time (the earlier the better) and letting the investment stay. But the boon can turn into bane if you are the one paying it. Imagine a credit card loan with interest compounded monthly, with a 12% APR, then you are charged 1% each month mostly on the average balance you carried for the month.

If your average credit card balance is 20,000 for the month, your interest charge at 1% for the month would be 200. Add 200 to 20,000.  Next month, charges will be on on 20,200, so your interest would be a little higher, at 202.  Over time, though, the extra adds up, since you continue to pay interest on your interest. Now convert this to say 1 million and do the math.

Compounding is useful in our daily lives

While the concept of compound interest has always been used in financial connotation, the bearing is across. Think about Sachin Tendulkar becoming of the greatest cricketer of all time. Wasn’t that the compounding effect of years of hard work and sweat? Isn’t the spread of Corona Virus a compounding effect too? Or how about a movement?

Though I can go on with as many instances, I am going to end my two cents saying, ‘compound interest has been and will always be’. And one of the ways to leverage the benefits of compound interest is through consistent investment even if it is a meager sum. But that is a story for another time…

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Swati is a Chartered Accountant with 6 years of experience working with some of the biggest global brands. While her profession demands number-crunching, she is a story-teller at heart. She loves travelling and meeting new people. Connect with her on LinkedIn for stories and more!

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