POWER OF COMPOUNDING

Albert Einstein is quoted as saying, "The most powerful force in the universe is
compound interest." We can say it to be the “Eight Wonder of the WORLD” The
concept is clichéd, overused from an investment perspective; it may be ill-timed to reiterate
the power of compounding, especially when the market is down in the dumps.

Disciplined investment can go a long way, one need to get bogged down by intermediate
glitches such as these. Anil Jha, 25, a computer consultant walked into my office; he had only
one goal: he wanted to become a millionaire. No, he wasn't inspired by the movie Slumdog
Millionaire. In real life it is not all lucky enough to win a million on a game show. He wanted
to put his money to hard work!

What is compounding?
Here we are trying to define the mathematical term; the achievement of academics is to apply
them in daily life. The wonder of compounding is to make your money work for you.
Compounding is the process of generating earnings on your asset's reinvested earnings.
Compounding works on two basic premises: re-investment of earnings and time. The longer
time you leave your money to compound, the higher is the wealth you generate.

"Time is the most powerful weapon in an investor’s arsenal. Nothing comes close to it." The
mantra is to start Investing early in life and do not get late at all. Also it shows how powerful
compound interest and regular investing is. When we invest early in our lives, the amount
keeps growing and when it becomes a big chunk, the growth in amount every year is a lot
more, compared to initial years.

Compounding Effect – Rice on Chessboard

A courtier presented the Persian king with a beautiful, hand-made chessboard. The king
asked what he would like in return for his gift and the courtier surprised the king by asking
for one grain of rice on the first square, two grains on the second, four grains on the third etc.
The king readily agreed and asked for the rice to be brought. All went well at first, but the
requirement for 2n - 1 grain on the nth square demanded over a million grains on the 21st
square, more than a million on the 41st and there simply was not enough rice in the whole
world for the final squares.

The total number of grains of rice on the first half of the chessboard is 1 + 2 + 4 + 8 + 16 +
32 + 64 + 128 + 256 + 512 + 1024 … + 2,147,483,648, for a total of exactly 232 − 1 =
4,294,967,295 grains of rice, or about 100,000 kg of rice, with the mass of one grain of rice
being roughly 25 mg.

The total number of grains of rice on the second half of the chessboard is 232 + 233 + 234 …
+ 263, for a total of 264 − 232 grains of rice. This is about 460 billion tones, or 6 times the
entire weight of the Earth Biomass.

On the 64th square of the chessboard there would be exactly 263 =

9,223,372,036,854,775,808 grains of rice. In total, on the entire chessboard there would be
exactly 264 − 1 = 18,446,744,073,709,551,615 grains of rice.

The Chessboard story is a mind boggling illustration of how the power of compounding can
do wonders which is dubbed as “The 8th Wonder of the World”. Now that we understand
how powerful compounding is, lets us look for ways to make use of this principle to multiply
whatever money we have. Now if you are saying you don’t have, relook at your expenses,
and get out of debts and start saving now, no matter how small to start with. Put your plan
into ACTION.

Compounding Effect – 18 hole Golf Course

Let me give you another example to illustrate the power of compounding. Let's say we played
a game of golf and we made a friendly bet of 10-paisa on the first hole, with the bet doubling
on each hole. Would you take on this bet? Now, if you were familiar with the game of golf,
you would know that there are only 18 holes, so how much can the bet be on the 18th hole?
Well let's see how the bet increases on the first 9 holes:

Hotel 1 Hotel 2 Hotel 3 Hotel 4 Hotel 5 Hotel 6 Hotel 7 Hotel 8 Hotel 9

12.80 25.60
10 Paisa 20 Paisa 40 Paisa 80 Paisa 1.60 IRS 3.20 IRS 6.40 IRS
IRS IRS
At the 9th hole, the bet is IRS 25.60. We are already half way there, so how much could it be
on the 18thhole? IRS 100? IRS 300? IRS 500? Let's go on.
Hotel 10 Hotel 11 Hotel 12 Hotel 13 Hotel 14 Hotel 15 Hotel 16 Hotel 17 Hotel 17
102.40 204.80 409.60 409.60 819.20 3,276 6,553
51.20 IRS IRS
IRS IRS IRS IRS IRS IRS IRS
Hotel 18
13,107
IRS

As you can see on the 18th hole, the bet becomes a whopping IRS 13,107! When given
enough time, the power of compounding can turn very small amounts of money into huge
sums.

A more important lesson I want to illustrate is that initially, the money grows very slowly.
Even at the halfway mark, it is only IRS 25.60. However, the moment it reaches a critical
point, the growth becomes exponential! In fact, between Hole 15 and Hole 18, within just 3
holes, it grows from IRS 1,638 to IRS 13,107, an IRS 11,469 difference!

What does this mean to you? You see when you start your investment program of say IRS
1,000 a month; initially the growth is extremely slow. However, once it hits a certain period
of time, the growth explodes exponentially! The trouble with most people is that when
they see the slow growth during the first few years, they lose patience and abandon their
investment plan.

MANTRA FOR “COMPOUNDING SUCCESS”:

Start early
Benefit from compounding There is no truth to statements like ‘I am too young to start
saving’. For example, if you want to be crorepati by 45, you would need to invest only Rs.1.6
lakh per year if you start at the age of 25 (assuming 10% returns p.a.). But if you start at the
age of 35 you will need to invest Rs.5.7 lakh per year to achieve your ‘crorepati at 45’
objective. If you start saving and investing early, it will set the stage for significant financial
growth later in your life.
Have realistic expectations
Greed is bad Most people invest in stocks and expect them to double in quick time. If you
want to double your money, either buy a lottery or go to a casino (but be prepared to lose
everything). Stock market is not gambling. The market is ultimately a reflection of economic
growth. As such one needs to align one’s expectation of returns in line with the expected
GDP growth.

Compare
The performance of your portfolio with relevant benchmark indices and develop realistic
expectations. Expecting unreasonable returns will surely cause disappointment, leading to
excessive risk-taking.

Invest regularly
Use time not timing Market timing is impossible. You may be lucky once or twice but history
has not produced a single investor who has made money regularly by timing the market.
Don’t panic when the market is dropping and don’t become greedy when prices are rising.
Emotions can be the greatest enemy to your long-term investment plan. History has shown
that when most investors are selling, you may have been better off buying.

Stay Invested
Be a marathon runner The markets have seen lots of ups and downs, but history shows that
over time the value of a well-diversified portfolio will increase. That’s because prices don't
rise every day – they spurt only during a few short intervals of time. Stay invested for longer
periods. It will keep you from making common mistakes such as timing the market, picking
bad stocks, speculating on stocks that are worthless, investing on borrowed money, trying to
make a killing in some fad-of-the-day stock, etc. The reason most people don't get rich with
stocks is that they don’t stay in long enough.

Don't churn your investments

It only increases costs Don’t buy stocks. Buy businesses and that too after due research. And
since businesses generally don’t change fortunes overnight, there is no need to get in/out
frequently as and when some short-term events play out in the market. Too-frequent trading
cuts into the investment returns more than anything else. Remember that the only person who
makes money in regular churning is your broker.

Asset allocation
Each investment class is important Build a portfolio that is diversified among different types
of investments. Because different sectors of the market move at different times in different
patterns, asset allocation tends to reduce the risk of huge losses and improves the chances of
stable returns. Lack of a well-diversified portfolio, would leave you vulnerable to fluctuations
of a particular investment. However, remember not to over-diversify and own too many
investment products – more so if the corpus is small – resulting in higher fees relative to the
corpus size.

The story of the King and the Sage & The power of compounding.
The story of the king and sage.
Once Upon a time there lived a King who was generous
and kind to the poor and needy. He always cared to
respect and reward scholars for their knowledge and
wisdom.
Hearing about the generosity of the King a poor Sage
came to meet him at his palace.
The sage presented a poem which he has written in front
of King. Impressed by the quality of the literary work, the
king asked the sage to name the reward he wanted.
“Are you sure that I can ask anything?” the sage asked.
“Sure. you may ask anything you like.” King replied.
Then the sage pointed to the royal chess board and asked " Your
majesty, In that 64 box board, in the first box kindly put 1 number of
rice grain , in the second double of 1 ,i.e. 2 , and in the 3rd box double of
2, i.e. 4 and so on utill we reach 64 boxes”. “I want that much grains only
as your reward”
“Are you sure? You want only grains not gold or diamonds?”. King asked.
“I am sure , your majesty,” The sage replied.
Royal servants started putting grains on the chess board as per sage’s
requirement, as per the calculation below.
 Box Number of Box Number of Number of
number grains of rice number grains of rice Box number grains of rice

1 1 11 1,024 21 1,048,576

2 2 12 2,048 22 2,097,152

3 4 13 4,096 23 4,194,304

4 8 14 8,192 24 8,388,608

5 16 15 16,384 25 16,777,216

6 32 16 32,768 26 33,554,432

7 64 17 65,536 27 67,108,864

8 128 18 131,072 28 134,217,728

9 256 19 262,144 29 268,435,456

10 512 20 524,288 30 536,870,912

You can see that at 30th column they had to put 536 million grains of rice. By the time they reached
the last box the King had to give the kingdom to the sage to fulfill his word.
The king failed to see and understand the ploy of the sage , who by doubling the value in each box
was cleverly putting compounding effect in to his advantage.

What is compounding
Practically Compounding happens when the interest gets added to the principal amount and from
then on will earn the interest for the total amount.
The addition of the interest earned to the principal is called compounding.
Please consider the following table.

Year Amount Rate of interest Total

1 1000 12 1120

2 1120 12 1254

3 1254 12 1405

4 1405 12 1574

5 1574 12 1762

6 1762 12 1974

7 1974 12 2211
An amount of 1000/- is the initial investment ( Principal) which earns 12% interest every year. At the
end of 1st year the interest of 120/- gets added to the initial investment and total value is 1120/-.
At the end of second year the interest is calculated for 1120/- not 1000/- , which is 134/-.
Like this money gets compounded year on year and at the end of 7th year the total value will be
2211/-. i.e. the income of 1211/- from the initial investment of 1000/-.
This is the power of compounding.

The power of compounding is the secret behind great returns from long term investments.
If you have the patience and discipline to save and invest small amounts when you are young, the
power of compounding will ensure amazing returns in the future.
Young professionals should start investing , even if it is a small amount, from the first salary.
So that compounding can help him to make a real fortune by the time he retire.
So don’t wait anymore… Start investing today…

POWER OF COMPOUNDING- SECRET OF CREATING WEALTH

All of us must have learnt about compounding and its significance sometime in school.
However, recently, we came across an interesting story which explained the power of
compounding wonderfully. Here it is…

Once upon a time there was a king known for his generosity and keeping his word. A famous
and intelligent prisoner was awaiting his death sentence and was brought in front of the king.
The king was playing chess when the prisoner was brought in front of him. Here’s the
dialogue that followed.

King: What is your last wish?

Prisoner: Your Majesty, I wish to make provisions for my family to survive after my death.

King: Well! Tell me what you want.

Prisoner: Give me the number of grains of rice on the last square of the chess board, if a single
grain was kept on the first square and then doubled on every next square (1 on first, 2 on
second, 4 on third, 8 on fourth, 16 on fifth and so on, till the 64th square), and I shall give it to
my family before I die.

King: (thinking what a paltry demand the prisoner had made) Wish granted.

The king then ordered his ministers to have the amount of rice calculated and given to the
prisoner. But he was in for a rude surprise. The amount calculated was so large that the king
lost his entire kingdom and was indebted to the prisoner all his life.

So, what would the rice be worth today? We at MoneyWorks4me.com thought of playing
with numbers and here’s what we found out.
Considering rice to be priced at Rs. 22.5 per kg ($500 per M ton) and every grain of rice to be
of 20 mg, the rice that the prisoner got, would be worth a humongous Rs. 41,50,51,742 crore
or just above $92 trillion.

With this he could easily buy the GDP of the entire world.

In fact, this figure was arrived at considering very conservative estimates and assuming that
the prisoner was given the worst quality of edible rice. If he was given a little better quality of
rice, he would have very well been in a position to afford both the global GDP and global
market capitalization.

Had the king not underestimated the power of compounding, we would have missed a
wonderful story.

What’s
in
it
for
you?

Understanding compound growth:

Most of us have learnt about compound interest in our school. It is nothing but the effect of
interest getting added to your capital, earning further interest. Take a look at the table below to
understand the difference between simple and compound growth.
Thus in simple growth the base on which the investor earns remains the same whereas in
compound growth the base increases with the amount earned in every cycle. Thus after five
years the earnings in case of simple growth is 5,000 (50% of 10,000), whereas in case of
compound growth the earnings are 6,105 (61% of 10000.)

The difference becomes more and more significant with larger periods as Simple growth is
linear and compound growth is exponential.

Compounding does its wonders through two tools, compounding rate and the number of
compounding cycles.
Compounding Rate:

Compounding rate is the percentage by which the Investment (rice in the above story) grows
with every compounding cycle. In the above story the compounding rate was 100 percent.
Though it is extremely difficult (impossible over long period) to get a compound growth of
100%, even a modest 15% to 20% rate can do wonders for us. In fact even a difference of 2%
can add significantly to your wealth. Take a look at the table below to see the growth of a
portfolio of Rs. 10000 growing at the respective rates.

Compounding Cycle:

Compounding cycle is a factor like time (or a square on chess board as in the story) in which
the investment grows by the compounding rate. This period may be one day, one month, one
quarter or any period. Generally one year is the most frequently used compounding period
(CAGR).

For compounding to become attractive, it should be allowed to undergo sufficiently large

number of compounding cycles. Just consider that the chess board was 7 x 7 instead of 8 x 8.
This would give the prisoner 49 compounding cycles instead of 64 and reduce his worth to Rs.
12,666 crore or around $ 2.8 billion, sufficient to buy just a Mid-cap company. The latter
compounding cycles contribute more to your wealth as the base on which your wealth
compounds grows larger with each cycle.

When investing in stocks for the long term, we routinely hear the term CAGR which signifies
the rate at which your investment grows every year. At MoneyWorks4me.com, we consider
that when you invest in stocks, you should earn minimum 15% CAGR. The MRP
(intrinsic worth) of a stock that we calculate is based on this assumption. We also say that
to reduce your risk, you should always invest in a stock when it is at a 50% discount to its
MRP. Doing this will in fact lead to a higher CAGR of greater than 20%. Have a look at the
table given below to understand what you would earn if u were able to grow your investment
of Rs. 10,000 with a CAGR of 10, 15 or 20 %.
From the above table we can clearly draw two inferences:

 A small percentage increase in the growth rate significantly increases the returns.
 The returns in the latter years are more impressive due to the higher base effect. Thus
longer the period, more attractive the gains.

The famous Value Investor Warren Buffet grew Berkshire Hathaway Book value from $19 in
1965 to $95,453 in 2010(45yrears) with a CAGR of 20.2 %.

Over long periods Stocks give a CAGR of more than 15%. SENSEX has given a return
of 17.8% CAGR since 1978-79 over a period of 32 years. By understanding and effectively
applying the principles of value investing, an investor can definitely achieve a CAGR of
above 20% over long periods.