Once upon a time, in a land not too far away, there was a King. Every now and then, the King would have his subjects put on a talent show for him. On one such evening, a villager named Ganga came along. Ganga had a beautiful voice, and that evening, she sang a song so soulful, that it left the King enthralled. He was mighty impressed with Ganga, and as a reward for lifting his spirits, the King offered her anything she wanted. Ganga thought for a moment and said, “O King, I lead a simple life. The month of May is just around the corner, and I need to buy provisions for the family. If you could give me one grain of rice starting tomorrow, and double it every day, for the remaining 30 days of the month, I would be extremely grateful to you.”
The King looked puzzled by how specific the request was but agreed to it instantaneously. His minister, however, grimaced.
Can you venture a guess as to why the minister wasn’t pleased? Doubling something as small as one grain of rice for 31 days sounds harmless, doesn’t it? But what was it that the minister had caught, that the King had missed?
The Power of Compounding
Back in school, I remember learning about simple interest and compound interest. Solving those mathematics problems was fun. But I hardly ever pondered over the implication that these concepts have on everyday situations.
Mathematically, a simple interest of 10% per annum, means that one would earn 10% of the value of investment (say ₹1,000 earned on an investment of ₹10,000) for the duration of the investment. Let’s say one stays invested for 5 years, the value after this period would be ₹15,000 (₹10,000 plus an interest of ₹1,000 for each of the years).
Now, compound interest works differently. Say the same ₹10,000 was invested, but it was compounded annually. The value after the 5-year period would be ₹16,105. This is ₹1,105 more than what we earned through simple interest. The reason is that each time we earned interest, it was re-invested rather than paid out. This re-investment results in higher returns since 10% is calculated on a higher amount every single time.
In the World of Finance
Meet Tanya, Kareena and Anamika. All three of them invest regularly, with one significant difference – the age at which they start investing. If we consider a compounded annual growth rate of 10%, there is a stark difference in the value of their investments when they turn 60!
Although all three of them have been investing consistently, starting early gave Tanya an edge. The benefit is evident. When it comes to investing, as Morgan Housel rightly says, “the skill is in choosing the right avenues, but the secret is time.”
Speaking of different investment avenues, most of them offer us compound interest. This is clear with avenues like the PPF and Fixed Deposit, where the interest earned is fixed. But the same is also true for avenues like mutual funds and the stock market. The earlier and longer you stay invested, the better.
Albert Einstein famously said, “Compounding is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”
How Compounding can Work Against Us
The concept of compounding also applies to loans and credit cards, where we pay EMIs, and the bank earns compound interest on what we pay. And this is not just a regular rate of interest. It goes as high as 30-50% in case of credit cards. Which is why we must be attentive to interest rates, and know how they can impact us.
The Magic of Compounding in Everyday Life
The power of compounding isn’t only seen in the finance field. Compounding spreads its magic dust everywhere. Think about how habits multiply, how the company of good people rubs off on those around, how seeds of knowledge turn into big ideas, how kindness has ripple effects, and how technology has grown exponentially. The most pressing of examples, though, and an example of how this concept works against us, is the current situation in India – the rapid rise in the number of people contracting the virus.
“Good and evil increase at compound interest. That’s why the little decisions we make every day are of infinite importance.”
CS Lewis
Let’s come back to our King’s decision to grant Ganga the rice she wanted. As is the case with most of us, the King’s thinking was linear, not exponential. He failed to imagine the number of grains that Ganga would receive by the end of May. If one kilogram of rice is approximately 50,000 grains, Ganga’s house was going to be filled with 21,474 kilograms of rice. That is the power of compounding.
P.S: A chapter called, “Confounding Compounding” in the book, The Psychology of Money, talks about how this concept played a major role during the ice age. It’s quite intriguing! Just in case you haven’t gotten your hands on this gem of a book yet, do give it a read sometime soon (the earlier the better!) 🙂
P.P.S: To share this article further, use this link – bit.ly/rupiko-power-of-compouding. Let’s spread this magic dust, shall we?
