Musing 3: The Eighth Wonder of the World
MUSING
3: COMPOUND INTEREST
THE
EIGHTH WONDER OF THE WORLD
There
is this famous story, probably apocryphal, that Albert Einstein once termed the
Compound Interest as the Eighth Wonder of
the World. While this may or may not be true, if there is only one concept
from this book that I wish to leave with you, it is to understand and
internalize the power of compound interest.
Like all great powers it can be harnessed to achieve absolute financial
freedom or conversely it can land one into penury in the sunset years, all
other factors remaining same. To explain this and subsequent concepts, let me first
introduce you to the gender neutral protagonists of this fable-Anshreya and
HoneyCool. We will also recapitulate as to what we mean by Compound Interest.
Compound interest is the addition of interest to
the principal sum of a loan or deposit, or in
other words, interest on interest. It is the result of reinvesting interest,
rather than paying it out, so that interest in the next period is then earned
on the principal sum plus previously accumulated interest[1].
Anshreya is 25
Years old and has just started earning with a decent and stable job in the
field that he loves. His take home pay-after taxes and other deductions is Rs
50000 per month and he currently has no liabilities including student loan, Home
loan EMIs etc. Being a financially wise and savvy youngster, he decides to
invest 20% of his take home pay-Rs 10000 per month into a financial instrument which
over long term gives him a return of 12 %
(We will tackle the types of instruments available later). Anshreya has
a friend, HoneyCool, who wants to enjoy the life in the initial years of his
earning career and decides to start investing after five years. So, he
starts investing the same amount ie Rs 10000 per month after five years and
manages the same returns as Anshreya. Both invest religiously till they retire
at the age 60. What would be the difference in their retirement corpus with the
delay of just 5 Years over 30/35 years of earning life? Take a guess (all examples
factor in annual compounding). Well,
Anshreya ended up with a retirement corpus of approximately Rs Five and a half crore
wherein his” living his life” friend HoneyCool
ended up with only Rs Three crore -not a bad amount overall but really
peanuts in front of what Anshreya accumulated.
And mind you, here we are not considering the fact that Anshreya
will keep on increasing his investment amount every year in line with his pay
raise to cater for inflation, so the actual final corpus will be even more
formidable. How formidable? Well, if both increase their contributions by 6%
each year (the likely Inflation rates), Anshreya ends up with a corpus of HOLD YOUR BREATH, Rs Nine and a Half crore while
HoneyCool is still a distant second with Rs
Three crore and Seventy lac.
What this additional amount, of nearly Six crore, is
going to do to Anshreya’s sunset years can well be imagined. The annual visits
to exotic foreign locations travelling Business class and staying at choicest
of the hotels and Villas, buying expensive and valuable gifts for her near and
dear ones, ability to fund education of her grand children and contribute
handsomely to social causes which she held so dear all her life besides leaving
behind a rich financial legacy to her offsprings. And what was the sacrifice
she had to make for this blessed 25-30 years of retired life, a bit of frugality
for first five years of her life, not a bad bargain? Remember, being frugal is not
the same as being miserly.
But like all great powers like wind, water, fire et al.,
compound interest can also cause serious damage if not harnessed carefully. To
continue with our example, HoneyCool was not able to invest his money as wisely
as Anshreya for variety of reasons (we will tackle them later) and managed a
return of 10% instead of 12% that Anshreya did. Well now what will be the final corpus of HoneyCool-Barely Rs Two crore.
How does that compare with Anshreya’s corpus of Rs Nine and a half crore, not
very favorably I guess?
Key Chapter Takeaways
·
It is not important as to how much you earn
but how much of it you get to keep, and then put it to good use by investing
wisely. There are many Hollywood/Bollywood/Sports/Music celebrities who were
millionaires one day and yet died in penury.
·
The real power of compound interest is
experienced over longer periods of time. So, start investing with your first
pay check (even before if possible, after all we all get pocket money).
· Investing should be a habit, which should not
be dependent on other factors like festivals, visits, newly launched smart phone
etc. which demand extra expenditure. Once you decide on the percentage of money
you are going to invest each month, it should be sacred-never to be
interrupted. How much should one invest, will follow in the book.
·
Invest wisely to protect your capital and
grow it at a handsome rate. We will tackle both these issues subsequently.
·
Resist the temptation to dip into the corpus
for any want-the power of compounding punishes even one missed inflow.
Good effort anand
ReplyDeleteRequest to write something on tax saving means beyond the obvious ones like 80C, mediclaim etc.
Eg 50000/- in NPS etc
Yes, will be covering this topic too as I go along. Thanks for following.
Deletetaking out part of the money and investing in the securities which will give me a fixed rate of return compoundable annually is good for those who want to make safe investment.
ReplyDeletebut the guy like me who are financially literate would rather invest in equity market or new business on long term basis which would give a huge return at the end.
compounding is also dependent on time and risk in the market.
Very apt insight. I will be covering the issue of risk and reward in my subsequent musing. Thanks.
DeleteSir, You have nicely explained the importance of timely investment.... looking for your guidance on right type of investments.
ReplyDeleteComing very soon Ravi. Initially I am just drawing a road map with logic of investing. Thanks for following.
ReplyDeleteLate but never too late... Recommended reading for all kids
ReplyDeleteThanks for following
Delete