Finance 101: The Power of Compounding
In the year 2014, I passed my final term Engineering exams with flying colors and was already placed with an IT firm in Mumbai for the role of an Analyst. We had a 3 months training period during which I was in Pune and those were one of the best days of my life. We had to just prepare and take classes for 8 hours and then practice programming for 1 more hour. Things changed when we received our first salary, it was close to 23k, and coming from a middle-class family I never had the opportunity to spend so much money on my own. I was flabbergasted, I didn’t know what to do and like any other 22-year old I spent all the money on a party, in fact, I had to ask my father for an additional 5k at the end of the month just to pay the rent of PG. I sometimes wonder how much money would I have if I could save some part of the salary that I was getting for 3 years. I have recently started investing in Stock Market and Mutual Funds, and it took me a great deal of research to understand the market and that is when I came across the practical concept of compounding. That is when I realized that if I would have saved just Rs. 3000 every month for 6 years, the money that I would have would be close to 3.64 lakhs if compounded annually at 16%. The total money that I would have invested would only be 2.16 lakhs. Now, 3.64 lakhs doesn’t seem much when compared to 2.16 lakhs, but what if I told you that if I had continued to stay invested in, the money would be close to 29 lakhs in the next 14 years and that is a 1242% increase on your initial invested amount.
Now, if you are on the other side of compounding that is if you are paying a loan and take a loan of around 13,50,000(avg. cost of MBA course in India) at only 7.6% for 15 years you will end up paying 22.67 lakhs which is close to double the amount of loan that you have taken. This is the power of compounding, if you understand it you earn it and if you don’t you end up paying it. So, let’s now be a fool and learn compounding to make money.
Everyone has different ways of compounding, the frequency of compounding varies across financial institutions. Most banks in India calculate interest on a daily basis and this is how you earn interest in your saving accounts. Below are the ways in which compounding is generally calculated:
1. Annual Compounding: Interest is calculated once every year.
2. Half-Year Compounding: Interest is calculated twice every year.
3. Quarterly Compounding: Interest is calculated every three months.
4. Daily Compounding: Interest is calculated every day.
Now, the main task behind understanding compounding is to understand the difference between these four compounding methods.
Suppose, we have 10,000 at our disposal and we need to invest it. Now there are four financial institutions that compound their interest rate as per different compounding types mentioned above. These will be the return that one will get from different institutions.
1. Annual Compounding: Rs. 11000
2. Half-Year Compounding: Rs. 11025
3. Quarterly Compounding: Rs. 11038.13
4. Daily Compounding: Rs. 11051.56
Now, the difference of Rs. 51.56 would not be significant but imagine if your investment is of 5 lakhs and you say invested for a period of 10 years at a rate of 15%, the difference will be close to 2.17 lakhs.
This is the power of compounding, which is generally not made understood to any of us in the traditional educational system, and thus according to a report in Business Standard only 3.17% of the Indian population invest in stocks compared to 55% of the USA population and it is not only about the people who have access to technology, it is about the general understanding of how much money is left on the table if the power of compounding is not engrained in the mindset of the population.
