Money Magazine - The Power Of Compounding

It is often said that “Money makes more money”. At first this might sound obscure, but yes, it is a fact that money can and it does make money. Let me tell you how you can make your hard earned money, work for you.

It might sound like some sort of “black magic” or “rocket science”, but it’s neither of those. Making your money work for you, rather than it being the other way around is possible – and it’s because of something called as “Compound Interest” - a concept that almost all of us have studied during our school days. A little knowledge of how compound interest work can go a long way.

Whenever we put our money in a saving account in a bank, we earn a certain percentage of money per that year’s interest rates, which are applicable on the savings account.

Simply put, compounding happens when the interest also earns interest in the subsequent year.

It is one of the biggest, easiest and probably the most convenient financial advantage anyone can access by simply opening a retirement account. The miracle of compound interest is the secret of getting rich slowly but surely. Those who get rich get there by spending less than they earn and saving the rest.

Just to share a few example of how compounding works, just imagine that you keep Rs 1000 in an account, which gives 10% interest every year. So how much will you have after a year? The answer is Rs 1100. Now how much after 5 years? The answer is Rs 1600. And any idea how much it will become after 25 years? It will become a much bigger Rs 10,830.

The interesting thing to note about compounding is that its real effect kicks in as the time of investment increases. It is not really about how much you invest. Rather it is about for how long you invest.

Rule of 72
In a scenario where you receive a constant annual rate of interest, there is a very neat thumb rule that can be used. It is called the Rule of 72.

Number of years to double your investment = 72 / (the rate of interest)

An investment that earns an annual interest rate of 12% would double the investment in 72/12 = 6 years.

Compound Annual Growth Rate (CAGR)
But there are times when the return on your investment may vary every year like in a mutual fund. In such cases the measure used to quantify the return is called CAGR (Compound Annual Growth Rate).

CAGR = (((Ending Value / Initial Value)^(1/No. of years))-1)

Suppose you invest Rs 10,000 in a portfolio on Jan 1, 2015. Let us say by Jan 1, 2016, your portfolio had grown to Rs 13,000. And then to Rs 14,000 by 2017, and finally ended up at Rs 19,500 by 2018.

Your CAGR would be the ratio of the final and initial value (19,500 / 10,000 = 1.95) raised to the power of 1/3 (i.e. 1 / no. of years), then subtracting 1 from the resulting number. It comes out to be 0.2493. Another way of writing 0.2493 is 24.93%.

Thus you CAGR for your three-year investment is equal to 24.93% representing a smoothed annual gain earned on your investment.

So don’t waste any more time and put your money to work for you.