The word itself says for itself. You must have gone through this phase when you come across articles or news related to the stock market. Compounding is not only about money, compounding happens to our day-to-day lives also. In fact, whatever you see around you, it's the result of an act that happened over time. Still, confused?
Let me give you a few examples to get through this.
Everyday scenarios of compounding
Everyone has lunch over their houses, right? You or your mom prepare those delicious foods which probably takes hours. A simple act as cutting and chopping the vegetables, and start preparing adds up to compounding. These small and simple tasks when compounded over time bring in the food. In the beginning, if you see, there isn’t much happening, there are some vegetables here and there and some spices lying around. But as time goes by, these dishes start to take their shape and finally, you have the prepared lunch to be served in your home.
When you have a small pain in your joints, at first you ignore them. But over time, the pain starts to increase and this can lead to other complications. The small neglected pain over time compounds to a larger pain. The sum you have to pay in the initiative would have been in nothing, just to take care of your joints. But since you neglected it, now you would have to pay a huge sum for treatment to correct this problem.
Everyone loves riding their car. When I was driving, I could hear small sounds in the shock absorbers. I probably thought it was some tiny problem and ignored it for few days. But over time, the sound got increased, and eventually, I had to go to the repair shop. The mechanic told me if I had brought it earlier the problem would have been just to fix the bushes which would have cost me 200 rupees.
Now, the shock absorber is also affected and I have to replace the whole shock absorber assembly which will cost me 5000 rupees. Had I been a bit conscious, this small problem wouldn’t have compounded over time.
Now you can see, everything is related to compounding, and now you can get a good view of how important is compounding to our day-to-day activities.
Interest
Interest is something you get for the capital you have paid to the bank. If you have deposited your money in your bank, your bank will pay you interest on your money. This applies if your money is parked in some Fixed deposit or savings account.
Suppose you have taken a loan from the bank, the bank charges you interest for the loan taken. If they are charging 10% and you have taken 1,00,000 (1 Lakh) as a loan, you would have to pay 10,000 per year as interest alone upon paying your capital. If you see, capital is something you have to pay to the bank by default, this interest is the money you are paying to the bank for their service of lending this huge amount. This interest is normally calculated annually and different banks have their own interest rates.
These interest rates are the one which attracts people into buying different properties. If the interest rate is less, people will take loans and start buying more. If the rate is high, they will be reluctant to take a loan, thus wouldn’t go for buying anything.
From the above words, interest can be applied when you give money and make money. Give money to the bank in terms of savings account and take money from the bank in terms of the loan. For the sake of this article, let's concentrate on interest when you park your money in the bank or start something like a deposit in the bank.
Simple Interest
As the words convey, simple interest is simple to calculate. Here, the interest keeps on adding from the base capital only, which is your initial capital.
Suppose you have deposited 50,000 in the bank for 10 years at 10% simple interest. Here, after each year, 10% of your base capital will be added to your account.
Let me show you from the below table:
Year | Interest | Interest Amount | Final Capital |
|---|---|---|---|
After 1st year | 10% | 5000 | 55,000 |
After 2nd year | 10% | 5000 | 60,000 |
After 3rd year | 10% | 5000 | 65,000 |
After 4th year | 10% | 5000 | 70,000 |
After 5th year | 10% | 5000 | 75,000 |
After 6th year | 10% | 5000 | 80,000 |
After 7th year | 10% | 5000 | 85,000 |
After 8th year | 10% | 5000 | 90,000 |
After 9th year | 10% | 5000 | 95,000 |
After 10th year | 10% | 5000 | 1,00,00 |
Thus, at the end of 10 years, you will be sitting with 1,00,000 in your hand. Isn’t that amazing. Just parking your money with your bank and the bank pays you interest. This is simple interest, unfortunately is not currently used to calculate your interest in your bank. A little more sophisticated compound interest is used to calculate the interest nowadays.
Compound Interest
Here the interest is not calculated over the base capital or your initial capital, rather we can say it's dynamic in nature. After each year, the capital which you have including the interest earned will be used to calculate the new interest. Let me show you an example.
The new interest amount will be from the final capital you will be having.
Year | Interest | Interest Amount | Final Capital |
|---|---|---|---|
After 1st year | 10% | 5000 | 55,000 |
After 2nd year | 10% | 5500 | 60,500 |
After 3rd year | 10% | 6050 | 66,550 |
After 4th year | 10% | 6655 | 73,205 |
After 5th year | 10% | 7320 | 80,525 |
After 6th year | 10% | 8052 | 88,577 |
After 7th year | 10% | 8857 | 97,434 |
After 8th year | 10% | 9743 | 1,07,177 |
After 9th year | 10% | 10717 | 1,17,894 |
After 10th year | 10% | 11789 | 1,29,683 |
Thus, for the table you can see, after each year the interest keeps on changing according to the final capital. While simple interest was paying 5000 interest at the end of the 10th year, compound interest was paying an interest of 11,789 at the end of the 10th year. Moreover, when you are calculating with Simple interest, the final capital you will be sitting with will be 1,00,00 while if the calculations are in compound interest, you will be sitting with 1,30,000 capital.
The huge 30% growth from the simple interest capital. The magic of compounding usually works when the time period is very high. When you are invested for a longer time frame, the higher compounding will take place, increasing your wealth exponentially. From the above example, in the initial years, interest paid to you was only 5000, but at the end of the 10th year, the interest has grown up to 11,000. That is a massive 120% increment from 5000.
Power of compounding
Imagine you plan to start investing in the stock market. You can either choose a Systematic Investment Plan or manually invest the said amount every month. You are determined to invest 10,000 per month into the stock market and made up your mind to keep this investment for 20 years. Maybe, you are planning to retire after 20 years, your 25 now and planning to retire by 45.
Let’s take a simple scenario as Nifty. By now you should be knowing what Nifty is. If not, Nifty is an index used to analyze our stock market. Nifty also tells about our economy, since it's the combination of 50 best companies in India. You have the option to buy Nifty bees, where the price goes in sync with nifty 50. And remember, nifty give an annual return of 10% year on year.
Let’s say, you are buying 10,000 rupee worth of nifty bees every month for the next 20 years. Let’s see how your capital grows over time and what will you be having at the end of 20 years.
From the above example, you can see your capital accumulated after 20 years will be just 24 Lakhs, but the interest gained will be 48 Lakhs and you will be having a total sum of 72 Lakhs at your disposal after the end of 20 years.
If we see this in the case of simple interest, then you will be sitting with a total capital of 24 Lakhs plus 2.4 Lakhs as interest earned. If the calculation was in simple interest, your total sum after 20 years would have been just 26 Lakhs. Compare this to your compounded interest of 72 Lakhs.
When we say compounding happens exponentially, we literally mean the capital is exploding exponentially. Let me show you the graph for the above-compounded capital.
As you can see from the graph, compare the initial balance, the total deposit made and the skyrocketing interest earned. If you ever want to take interest to your advantage, you need to have compounding interest.
Conclusion
Getting to know about compound interest and using it to your advantage is a whole new different skill level. Suppose you had invested in Titan back in 2000-2001 when the price was in the range of 9 rupees per share. And after 20 years, through all these hurdles and struggles, you still have the shares of Titan, as of today 17 Oct 2021, the price of titan's share is around 2400 rupees.
And don’t forget the dividends, stock splits, bonus issues, right issues you earn during the holding period. All this patience will bring you to a better investor and much wealthier investor in the coming days. As for your knowledge, the above-said person is none other than the Warren Buffet of India: Rakesh Junjunwala.