Compounding – the most powerful force in investing

At a glance

  • ‘Compounding’ is one of the most under-appreciated concepts in investing
  • Small amounts invested early and regularly with modest returns snowball into significant savings over time
  • Over a 40 year horizon, small amounts invested for the 1st eight years grow bigger than those same amounts invested annually for the next 34 years
  • To harness the magnificent power of compounding, start investing early, regularly and give it time

Back when I was a newly minted engineering graduate in my first job as an IT programmer, my idea of money was limited to the salary that went monthly into my account that enabled my ATM card to work. The bank was just a place that kept my money on my behalf and paid me some inconsequential amount as interest for the privilege. I thought, “Fixed Deposits” were the cutting edge of investments which required signing over your money for long periods of time and only to be indulged in by those who had in fact, money to spare. Money was something to be “made” through working long hours and idea that it was anything but a passive score-keeping commodity just did not exist.

In short, I was clueless about the power of compounding. And that, by far, is the most powerful concept in investing. So much so that Albert Einstein has been wrongly attributed to having called it “the most powerful force in the universe1

The Dow theory Letters

I’ll use a localized version of a famous study conducted by Richard Russell, writer of ‘The Dow Theory Letters2 that illustrates the power of compounding like no other.

Consider two friends, Aanya & Bikas, who graduate together and start working in identical circumstances (company, position, salary). They are both 24 years old when they start their careers. Now consider their investing behavior:

  • Aanya starts saving and investing ₹12,000 a year for the 1st eight years at 9% interest, then stops investing
  • Bikas doesn’t bother saving for those eight years but then starts investing ₹12,000 a year, also at 9%, from year nine for the next 34 years, until the time he retires, at 65

Chart shows how their savings accumulate by the age of 65

At the age of 65, Aanya has savings of ₹2.7 Million or 27 Lakhs while Bikas has marginally lower savings of ₹2.57 Million or 25.7 Lakhs. Deceptively close except when you consider that Aanya invested a lifetime total of ₹96,000 while Bikas invested ₹408,000 to be end up marginally worse off than A! So Aanya ended with 28x the money she invested while Bikas’s money grew by just over 6x.

Also consider that while it took Aanya’s savings 14 years to breach ₹5L, it took another 8 years to ₹10L, and just 5 years to ₹15L thus illustrating the “snowball effect” of compounding as it puts the accumulating interest to work for you to generate more interest.

power of compounding 2

Making compounding work for you

The two key takeaways from this example:

  1. Start Early, Regularly: the sooner you start saving and investing, the better your chances of achieving financial security while taking fewer risks with your money
  2. Give it time: while the effects of compounding are slow to begin with, they accelerate wealth accumulation at an accelerating pace over time

For those of us who did not have the epiphany to invest early in our careers, it’s never too late to start investing regularly. Applying robust stock selection criteria, staying invested and minimizing “impulse” trading can go a long way in building long-term wealth.

It might not be “the most powerful force in the universe” but compounding is certainly the most powerful force in the world of investing.

References

1 Quote mistakenly attributed to Einstein (snopes.com)

2 Dow Theory Letters

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