The story of compounding and its magic

Introduction

Albert Einstein once said, “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn't, pays it.” When you invest periodically and in the right assets, you provide your wealth with an opportunity to grow. Hard to believe, isn’t it?

It was exactly what the King of Ambalapuzha thought, and he learned his lesson the hard way. It's time to hear the Legend of Paal Paysam.

The Magic of Compounding – Illustrated Through a Story

Known for his love for chess, the King would challenge wise visitors to play a match with him. It is said that a king would offer any treasure or prize he wished to his opponent if the challenger achieved victory over him.

Upon arrival in the realm, the King challenged a travelling sage to play a game. Asked what reward he desired, the sage indicated that he had modest means and did not need much. He said, “Oh, Mighty King, my requests are straightforward. I can only hope for this. Please give me one grain of rice for the first chessboard square, two for the next, four for the one after that, eight for the next, and so on for all 64 squares. All I ask is that with each square, the number of grains is double the number of grains in the preceding square.”

To the King, this request seemed acceptable. So, he instantly agreed to it. Only when the King sat down to make the payment and began calculating how much grains would be required to fulfil the request, he understood that he would have to give away 18,000,000,000,000,000,000 grains of rice, or almost 210 billion tonnes, on the sixty-fourth square. A covering of rice one-metre-thick would be enough to cover the entire India. By agreeing to this request, the King bankrupted himself.

Compound interest also works in a similar fashion. The interest you earn on your money grows every year because the interest earns more interest. If you invest your money for long enough, your wealth has the opportunity to grow significantly.

Understanding Compounding and Its Importance with Examples

In simple terms, compounding is the process of reinvesting your earnings and generating additional returns. Basically, you earn a return on both your principal and your accumulated appreciation.

Let's use an example to grasp this better. Let's say you invest Rs 10,000 at a 10% interest rate.

*The above calculation is for illustration purposes only

So, when you reinvest the lump sum amount of Rs 10,000 for 10 years at 10% assumed rate of return, your wealth grows to Rs 25,937. Thus, demonstrating that compounding has a significant impact on your investments.

Need another example to illustrate how compounding works?

Over time, consistent saving on moderately risky financial products can provide excellent results. As a parent, if you begin saving Rs. 30 every day for your child from the day of their birth until they turn 25 years, at an assumed 10% compounded annual return, you will be able to accumulate Rs. 11.85 lakhs to give your child on their 25^th birthday.

This is a great way to teach your child about the benefits of compounding too. If they learn to invest in the same manner, they can become millionaires by retirement.

Maximising the Benefits of Compounding

Growing your wealth through compounding is a terrific idea. Here's what you can do to get the most out of the compounding process.

• Start Early

It is never too late to start investing – the earlier, the better. You can begin investing the moment you start earning money. It's still a good idea to start now, even if you haven't done so already.

• Adopt Discipline

You must be disciplined with your investments if you genuinely want to take advantage of compounding benefits and increase your wealth to meet your financial objectives. You must, therefore, begin your financial adventure and make sure that you make regular investments.

• Be Patient

Your route to wealth creation will take time. You must know that building a corpus that supports your financial objectives will take time. In the rice and chessboard story, the first ten squares added up were just approximately 2,000 grains of rice, but the magic started happening afterwards.

Takeaway

Compounding is an excellent method of growing your wealth over time. But the real magic happens over time. If you want to accumulate wealth and become rich, use the magic of compounding.

Disclaimer: ICICI Securities Ltd. (I-Sec). Registered office of I-Sec is at ICICI Securities Ltd. - ICICI Venture House, Appasaheb Marathe Marg, Prabhadevi, Mumbai - 400 025, India, Tel No : 022 - 6807 7100. The contents herein above shall not be considered as an invitation or persuasion to trade or invest.  I-Sec and affiliates accept no liabilities for any loss or damage of any kind arising out of any actions taken in reliance thereon. The contents herein above are solely for informational purpose and may not be used or considered as an offer document or solicitation of offer to buy or sell or subscribe for securities or other financial instruments or any other product. Investments in securities market are subject to market risks, read all the related documents carefully before investing. The contents herein mentioned are solely for informational and educational purpose.