Most Powerful Force in the world :

When the great Albert Einstein was asked which was the most powerful force in the universe was; he answered "compound interest" !!.
Now that's a very interesting observation from one of the most brilliant scientific minds in the world. But it does provide deep insight into what is considered a practical financial key to achieveing our financial goals. We are going to delve a little bit more into this topic and see its practical applications in our day to day investments and its outcomes.Compound Interest, a wonderful concept that we’re all introduced to while solving simple arithmetic problems in middle school many years ago. Now how much of this principle do we really understand and apply in our day to day lives from a money management and investment perspective??

Let’s go back to the basics: Compound Interest is calculated not only on the initial principal but also the accumulated interest of prior periods. Compound interest differs from simple interest in that simple interest is calculated solely as a percentage of the principal sum.

(Source: Source: http://www.investorwords.com)

The equation for compound interest is: P = C(1+ r/n)^nt

Where:

    P = future value

    C = initial deposit

    r = interest rate (expressed as a fraction: eg. 0.08 for 8%)

    n = # of times per year interest is compounded (eg. One time per year)

    t = number of years invested

Let’s look at the power of compounding with our money and investments with a double your money challenge:

Each of us have unique talents that can generate for us some professional revenue right??...so let’s play the game of compounding.

Does Rs. 1/- look like a formidable Capital/amount to any of you?? …nope!!... Can you at least double this money in one day using your unique professional skills and talents (Assumption: As a consultant you can charge whatever you want and also keep the remaining amount as a buffer for your professional services to continue playing the challenge, all I am expecting is double the one rupee given at the start of the challenge using your professional skills) …… sure you can, it does not look like a daunting task at all. (Considering that most urban working middle / upper middle class may be earning thousands a day by breaking down their monthly salary as a per day income). All you have to do is to earn one rupee the very next day, you could probably do it in your sleep!!

Let’s raise the stake …. if I were to ask you to double this amount earned (i.e. now Rs.2 /-) the very next day and make it Rs. 4/- , you would once again laugh it off and achieve it easily. But the challenge does not end there, now I would like you to do this each day consistently for One Month only  i.e. doubling the money generated the previous day (which started with a paltry One rupee on Day One) …. What do you think will happen??? 

At the end of the 30th day, the total amount accumulated could be close to Rs 107 crores!

This final amount is formidable and looks un-realistic to achieve in one’s life time, forget about achieving it in a month. The consideration to keep here is that I had actually set the challenge of making 100% compounded every day!!!

One of the most common questions we get as strategic investment advisors is, whether we can double (i.e. 100% returns) our clients money in one year?. Let’s be realistic, research has shown us that even geniuses in math and A.I. with all their computing power and market intelligence find it difficult to appreciate the enormity of the concept of even a more realistic compound growth while working for Global Hedge funds and money managers.

To logically answer this question let us look at one of the wealthiest man in the world who made his fortune purely on investments. He is none other than Warren Buffet and he has generated his wealth through an annual compounded growth on his portfolio of roughly 25% over the last 25 years. To consistently beat this rate of return over a quarter century would put you in the league of the super rich of the world.

The rule of 72:

This is simple formula to realistically know how long it would take for your initial investment to double (i.e. 100% gain) using a compounded rate of return. This would also help you in your planning to achieve a financial goal.

Solution:  Keeping 72 as a constant (in the numerator), we divide this constant by our expected rate of annual compounded interest.

For e.g. Expected annual rate of compounded interest = 8%

The duration needed for any initial investment to double = 72/8, which would be 9 years!!

So let’s take the power of compounding and compare it against our most common systematic  investment instruments over a 15 year period to build a retirement corpus.

Investment Instrument	Amount Invested annually	Rate of return (compounded)	Tenure of Investment in years	Total Amount Invested (at the end of tenure)	Final Amount (at the end of investment tenure period)
Gold (historic returns matching inflation)	1 Lakh	6%	15	15 Lakhs	24.67 Lakhs
Bank Recurring Fixed Deposits ( with 30% Tax rate adjusted yield)	1 Lakh	6.30%	15	15 Lakhs	25.31 Lakhs
Public Provident Funds	1 Lakh	8.50%	15	15 Lakhs	30.6 Lakhs
Equity Mutual Funds/ULIPS	1 Lakh	15%	15	15 Lakhs	54.71 Lakhs
Direct Equity - growth stocks	1 Lakh	22%	15	15 Lakhs	1.39 Crores

How much would you really need at the time of retirement is very subjective and may vary from person to person but the above illustration gives you a rough idea on various investment instrument options you have at your disposal (over a 15 year period) and its best case compounded rate of return for reaching your financial goal (e.g. potential final retirement corpus).    

As you can see the main trick in the power of compounding is the “Time Factor” hence the earlier you start with the appropriate investment instrument to meet your financial goal / retirement corpus need and longer the tenure of investments the larger will be the final retirement kitty.

DO not delay with your investment decisions to look for the right time to start (even if it’s only a Bank deposit FD). The only time you have to start saving and investing to achieve targeted returns as shown in the illustration above is Now!! Let the power of compounding start working for You!!

Apart from the illustration mentioned above there are innovative/hybrid ways to boost your overall rate of returns of your savings and investments, remember one of the primary objectives of your savings and investments is that combined they should beat annual inflation rate year on year which is not even being considered in any of the above illustrated examples.