“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” -Albert Einstein
What would you choose? Rs. 10,000 per day for 30 days vs Rs. 1 that would double the value for 30 days? Rs. 10,000 per day sounds fascinating, ain’t it? But it will give you Three Lakhs at the end of the month but the latter one will give over Fifty Lakhs. Surprised? Welcome, to the world of compound interest!
Compound interest possess magical powers, like hypothetically turning a rupee to 50 lakhs. The great part about compound interest is that it applies to money, and it helps us to achieve our financial goals, such as becoming a millionaire, retiring comfortably, or being financially independent.
Time, a major factor
Let's consider the case of two other investors, Manjil and Bikram, who'd also like to become millionaires. Say Manjil put Rs. 2,000 per year into the market between the ages of 24 and 30, that he earned a 12% aftertax return, and that he continued to earn 12% per year until he retired at age 65. Bikram also put in Rs. 2,000 per year, earned the same return, but waited until he was 30 to start and continued to invest Rs. 2,000 per year until he retired at age 65. In the end, both would end up with about 1 million (10 lakhs). However, Manjil had to invest only Rs. 12,000 (i.e., Rs. 2,000 for six years), while Bikram had to invest Rs. 72,000 (Rs. 2,000 for 36 years) or six times the amount that Manjil invested, just for waiting only six years to start investing.
Clearly, investing early can be at least as important as the actual amount invested over a lifetime. Therefore, to truly benefit from the magic of compounding, it's important to start investing early. We can't stress this fact enough! After all, it's not just how much money you start with that counts, it's also how much time you allow that money to work for you.
Interest rate and it's importance in Stock Market
Along with the time, the rate of interest also matters. Fewer deviations in interest rate can mean a huge difference. Again, let’s take above example but altering the interest rate of Manjil to 8% and Bikram being 12%. But this time, cleaver Bikram starts investing at the same age Manjil starts i.e. 24. Now, what would be their return? Manjil would have earned about 2.5 lakhs against Bikram's 10 lakhs. If there was another guy, say Smaran investing from the same age but with 4% annual return, he would have earned just over Rs. 50,000. So, few percentage difference can mean huge difference in future wealth. Therefore, investing in stocks with constant return (if higher, better) than the stocks with fluctuating rates is better for a long run.
Thus, Compound interest can help you attain your goals in life. In order to use it most effectively, you should start investing early, invest as much as possible, and attempt to earn a reasonable rate of return.
On a final note, there is a philosophical saying yet applicable to compound interest: "In the beginning you struggle a lot to get things going and afterwards once it reaches to a point it just takes off smoothly". How does that analogy go again? It is something like starting a business is like a rocket ship taking off into space. You spend 80% of your fuel during take off and once it reaches a certain point it flies smoothly with minimal consumption. So, if you have already started investing then don’t be proud of yourself and INVEST MORE. And, if you haven’t INVEST NOW!!
Is there a tip for calculating the time for the money to get doubled for certain interest? Yes! You can use rule of 72. For example, if you wanted to know how many years it would take for an investment earning 12% to double, simply divide 72 by 12, and the answer would be approximately six years. The reverse is also true. If you wanted to know what interest rate you would have to earn to double your money in five years, then divide 72 by five, and the answer is about 15%.