In 2021, make compounding your new best friend

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One of the most popular, and almost certainly apocryphal, stories that’s often told to drive home the power of compounding is this:

Once upon a time in a land far, far away, there lived a clever man who invented the game of chess. Chuffed with his invention, he went to show it off to the king, who was immediately smitten by it. Thrilled, the king asked the man to name his reward.

The clever inventor told the king, “Your highness, I don’t want much. I only need as much rice as the 64 squares in this board of chess can hold; but I have one request: as you progress through the squares, please double the amount of rice. Therefore, if you start with one grain of rice on the first square, make it two on the second, 4 on the third, 8 on the 4th and so on.”

The king was surprised that the inventor wanted something as simple as that. Anyway, he asked his treasurer to go ahead and fulfil the inventor’s wish. Can you imagine the king’s disbelief when his treasurer came to him and told him that the stock available across the kingdom won’t be enough to meet the inventor’s request!

Here’s what happens when you start with one grain of rice on the first square and keep doubling the number every square till the final 64th square: 1 becomes 9223372036854780000. That’s nine quintillion, two hundred and twenty-three quadrillion, three hundred and seventy two trillion, thirty six billion, eight hundred and fifty four million, seven hundred and eight thousand grains of rice. That’s vastly more rice than the world produces every year. No wonder, then, Albert Einstein is said to have called compounding the eighth wonder of the world.

As an investor, you must make use of compounding to grow your wealth. In fact, it is the most important tool in your investment kit. For compounding to work, you need to plough back the earnings from your investment. For example, if your portfolio of 1 lakh rupees has generated 12,000 in profits at the end of a year, you need to put that profit back into your investment pool so that you start the next year with 1,12,000.

Now, two things happen when you do that: one, your principal corpus gets bigger and, two, your percentage returns on that larger base gets even bigger.

Let’s do some simple math to illustrate that example:

An amount of Rs 1 lakh with returns of 12% annually will give you Rs 12,000.

But 12% of Rs 1,12,000 is Rs 13,440.

Next year, your start with a corpus of Rs 1,25,440, 12% of which is Rs 15,052!

Now imagine, if the percentage of return were to increase as well. Your money will multiply at a stunning pace, without you having to do anything at all!

Since compounding is all about giving your investment time, it works best when you start investing young—ideally, with your first pay cheque. Waiting even a few years before you start systematic investment can make a huge difference to your goals.

For example, if you start investing Rs 2,000 a month when you are 20 for 35 years with an annual rate of return of 12%, you would be a crorepati when you celebrate your 55th birthday. However, if you waited until you were 30 to start investing the same amount for 25 years, you will make only 32 lakh rupees! In other words, waiting for 10 years reduced your earnings potential by a third!

Of course, starting early and staying the course requires a great amount of discipline and planning. I will tell you more about it, but in my next column.

(The writer is Managing Editor of TV9 Kannada, and formerly Managing Editor of ET Now and Business Today. Views expressed are personal)