The incredible power of compounding

The most powerful force in the universe is compound interest —  Albert Einstein

MUMBAI: Among the many similarities between New York and Mumbai, is the fact that both are island cities. Manhattan is one of the islands in the city of New York.

The story goes that the Indians of Manhattan, in 1626, sold Manhattan, to a group of immigrants for $24 in beads and trinkets. These Indians over the years have been ridiculed a lot. But as Peter Lynch and John Rothschild point out in their 1989 book, One up on Wall Street, they seem to have got a better deal than the people who bought the island.

Assuming that the Indians were able to convert the beads and trinkets into cash, the $24 compounded at 8% interest, would have amounted to $30 trillion in 1989 when the book was written.

While at the same point of time, as per the tax records, the entire real estate of Manhattan was worth only $28.1 billion.

Lynch and Rothschild further point out “Give Manhattan the benefit of doubt: that $28.1 billion is the assessed value, and for all anybody knows it may be worth twice that on the open market. So Manhattan’s worth $56.2 billion. Either way, the Indians could be ahead by $29 trillion and change”.

Even if the interest rate was lower by a couple of percentage points at 6%, the Indians would have ended up with $34.7 billion without having to spend money on the maintenance and upkeep of Manhattan.

This example clearly brings out the power of compounding. Compounding is essentially reinvesting the earnings from a particular asset rather than spending it.

So, in the example taken above, 8% interest on $24 would have been $1.92.

Now, instead of spending it, if the money were to be reinvested, the total principal would grow to $25.92. 8% interest on this amount would be $2.07 around 15 cents more than the previous year.

What this example tells us is that it’s important for an individual to start investing early, so as to give enough time to the money to compound. 

Money that is compounding can be thought of as a snowball rolling down the mountain, the longer the mountain is the more time the snowball spends rolling down, and the more snow it can gather along the way.

Lets take an example, of two brothers, Rajesh and Rakesh. Rajesh is elder to Rakesh by ten years. Both start investing at the same time, when Rajesh is thirty five and Rakesh is twenty five.

Both plan to invest Rs 70,000 per annum till their retirement, at the age of sixty. Assuming that they are able to manage a rate of return of 8% per annum, when Rajesh, the elder brother retires, he would have been able to accumulate, Rs 55,96,809. When Rakesh retires, he would have been able to accumulate Rs 130,97,150, almost 134% more. That’s the power of compounding. Compounding works really well with regular investing.

Also its important not to touch the savings and let it compound. If an individual keeps withdrawing savings in between, this obviously leads to a lesser amount of money accumulating.

Further, the rate of return that on the money that is compounding is really important. As is very clear in the Manhattan example, if we assume that the rate of return is 6% instead of the original 8%, the Indians would have ended up with only $34.1 billion which is small change in comparison to $30 trillion.

As the interest rates fell in the last few years a lot of people have had to suffer because of this. Charitable trusts, poor pensioners, senior citizens and widows saw the value of their savings come down considerably, as their savings compounded at a lesser rate of interest.