How Young Investors Can Use the Power of Compounding to Create Long Term Wealth

“Compound Interest is the eighth wonder of the world. The one who understands it earns it. The one who doesn’t, pays it.” – Albert Einstein

You must have heard of this powerful quote from the legendary genius. But have you ever wondered what made Einstein say so? And what did he mean when he said that those who don’t understand compound interest, pay it? This article explains the power of compounding to create wealth and meet financial goals, the effect of “negative” compounding and some simple tips on how to benefit from compounding in your financial journey.

What is the power of compounding?

Compounding is known to be one of the most powerful principles of wealth creation. Let us assume you invest some money and don’t withdraw the return. In that case, the return effectively gets invested, and it earns more return. In other words, the money earns money, and more money earns more money. Over time, this causes a domino effect whereby your money grows to a substantial amount.

Let us understand the above with the help of an example. Anupam invests INR 10,000 per month for 30 years in an investment that generates a 10% return every year. The below table captures three scenarios and the value of investment corpus as it grows in each of the three scenarios:

Scenario No. Details Corpus total (INR Crores)
1 He does not withdraw any money during the entire period of 30 years. 2.17
2 He withdraws INR 5 lacs each around year 5 and year 10.  1.29
3 He withdraws INR 5 lacs each around year 20 and year 25. 1.96

We can come to the following conclusions from the above:

  • Anupam invested only INR 36 lacs during the 30 years and did not touch the money in all these 30 years (Scenario 1). The corpus grew to INR 2.17 crores!! This is the power of compounding for you.
  • As a result of withdrawing INR 10 lacs in the initial years (Scenario 2), the overall corpus value came down by a staggering 40% (compared to Scenario 1). Lesson – DO NOT interrupt compounding in the initial years as it can significantly impact the long-term wealth creation.
  • Anupam did the same interruption towards the end of the investment duration. This resulted in a far less impact on the end corpus value, i.e., only 10% (as compared to Scenario 1)

Negative compounding – how does it happen?

Similar to positive compounding that happens when you invest your money, you can also suffer from the consequences of negative compounding. An example is when you get a loan and do not repay it for extended periods. The larger the duration of non-payment, the exponential will be the overall interest charged on loan. The higher the rate of the loan, the greater is the impact of negative compounding.

That is why you should try and save yourself from personal loans and credit cards. Because you don’t know how soon the negative compounding effect can make the outstanding amount balloon into an unmanageable amount. Apart from this, delay in repayment also affects your credit score.

Some tips to benefit from the power of compounding in your wealth creation journey

Below are some simple ways that you can apply the power of compounding in your life:

  1. Start saving as early on in your job/career as possible. Ideally, saving should start from the day that you get your first salary. Start setting aside 10% of your income for your financial goals. That way, you allow more time for the power of compounding to work.
  2. Understand the fact that wealth creation is a slow journey. It requires patience and faith. Most people miss creating wealth in their life to pursue “fast returns” and end up losing money by investing in risky and toxic products.
  3. Equity is the go-to asset class if you want to create wealth. But don’t blindly invest in it without knowing how it works. This will help you ignore the short-term volatility that comes with it and prevent you from liquidating your equity investments in volatile markets.
  4. Stay away from personal loans and credit cards as much as possible. Make a splurge fund and plan for your purchases in advance. Save a small sum over a few months and then buy the product. This will save you from the interest costs and harmful effects of negative compounding.
  5. Live a simple life. Choose a company of simple people. Often people fall into the trap of peer pressure and create a lifestyle for themselves which they find challenging to get out of. This lifestyle gets them into the prison of credit cards and personal loans. The simpler you live, the more money you will have to save and invest. Limit your social media engagement. Meditate for some time every day, as it rewires the brain and calms down our innate impulsive tendencies.
  6. Tag your investments to your financial goals. This can help you control the temptation to withdraw the money at the first available temptation and keep you focused on the financial goal.
  7. Prefer investing in the growth/cumulative interest option in the case of investments. This will help in the compounding of the investment returns over time.

Conclusion

Money makes money. This is a simple secret that, if understood correctly, can help you achieve financial freedom and live a decent retirement. The mantra is to start early, save as much as possible, and keep the money invested for an extended period. A sensible lifestyle and focus on financial planning can go a long way to help compounding work for you in creating long term wealth.

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