Compound interest works in a mysterious manner which can often be quite non intuitive to understand. It is a simple principle in mathematics which explains how small returns can compound to a big effect over a long period of time. When compound interest is applied to an asset (such as stocks), it explains the exponential rise in the price of the stock over a long period of time.
Simple interest vs Compound interest
Simple interest is the process by which an asset (such as stocks) provides a return to the asset owner assuming that the asset owner cashes out the profit regularly. Compound interest is exactly the same as simple interest except the asset owner doesn’t cash out the profits. This small change in approach is enough to cause a massive difference in terms of the output.
Let’s consider an example. Ram invested Rs. 10,000 in a stock which provided an annual return of 12% for 10 years. Shyam also invested the same amount in the same stock for 10 years. Ram cashed out his profits every year whereas Shyam didn’t cash out his profits until the end of 10 years. Let’s check the difference in the outcome.
Ram & Shyam invested the same amount of capital in the same stock for the same time period. Shyam earned a profit of Rs. 18,531 whereas Ram earned a profit of only Rs. 10,000. This difference occurs because Shyam never removed his profits. Shyam turned his Rs. 10,000 to Rs. 11,000 (just like Ram) but his choice of not removing his profits made him earn 10% return on his entire capital of Rs. 11,000 which kept on compounding till the end of the 10th year. This meant that Shyam’s effective capital kept on increasing year on year whereas Ram’s effective capital stayed stagnant due to regular withdrawal of profits. This is the power of compound interest which caused Shyam to make almost double the profits of Ram in 10 years. This gap between the profits of Ram & Shyam would have kept on widening had both stayed in the stock even after 10 years.
Another example which shows the power of compound interest is the average salary of Indians. The average salary of a middle class Indian was about Rs. 5,000-10,000 per annum. Compared to today, the average salary of a middle class Indian is about Rs. 3-4 Lakhs per annum. This exponential increase in salary is the effect of compound interest working silently over decades.
Three factors for compound interest
There are three main factors which are needed to calculate compound interest – principal amount, rate of return & time duration of the investment. Two out of these three factors can be easily controlled by the investor. In order to successfully compound your wealth, the investor must have a constant (or increasing) principal amount which is invested in the stock market for a long period of time. The factor which is the most difficult to control is the rate of return because it is impossible to predict the stock market. To learn more about why it is impossible to predict the stock market, visit this article! The rate of return will differ every year based on the market conditions & the stock selection of the investor. However, keeping a constant (or increasing) amount of capital invested in the stock market over a long period of time will ensure compounding of the investor’s wealth!
How to speed up compounding in wealth creation?
There are three easy ways to speed up compounding of an investor’s wealth.
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Investing more money
This is a no-brainer. Investing more money means that more money is working for the investor to generate higher returns in the stock market. 10% return on a portfolio of Rs. 1 Crore will be higher than a 10% return on a portfolio of Rs. 1 Lakh. Regularly adding to the portfolio will speed up the compounding process of the investor’s wealth.
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Reinvesting dividends
Many stocks provide a quarterly or annual dividend which the investor receives for being a stakeholder in the company. This is essentially free money which can be used by the investor to re-invest back in the stock market. This added capital can highly speed up the compounding process for the investor because more capital leads to higher dividends which again leads to even higher capital & so on.
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Avoid frequent profit bookings
As seen from the example, Ram was unable to make a big profit due to his habit of cashing out his profits. Regular profit bookings remove the money from the stock market, thereby slowing down the compounding of the investor’s wealth. Buying good stocks and holding onto those stocks for the long term is the only way in which investors can create huge wealth. To learn more about how to select a good stock, read this article!
Compounding can work both positively & negatively
Compound interest doesn’t just work in a positive manner to create big wealth for the investor. Many investors take huge risks in the stock market by taking up big loans to create a big portfolio. Just like the rate of return compounds the return of the portfolio, the interest rate on the loan compounds the interest payments which the investor has to pay back. Taking a loan (especially at a high interest rate) will compound against the investor & put them in a never ending debt burden. Always ensure that the compound interest is working in your favour!
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DISCLAIMER : I am not a financial advisor. I am not for or against any company which I have mentioned in this article. All the information provided here is for education purposes. Please consult a financial advisor before investing.
Contact me at investmentabshuru@gmail.com
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