The Snowball Effect: Compounding your Wealth to Riches

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In all my years of experience in the financial planning profession, I can surely tell that the science behind getting wealthy is very elementary. There is no secret to getting rich. Getting rich is not just confined to people who are earning high incomes or doing business or investing in properties or taking bets in stock markets, commodities, foreign currency, etc. Even an individual with average income can become rich. Let me show you how and prove with numbers.

A common Analogy to Compounding

As a snowball rolls down a hill, it picks up more snow making it bigger.  This in turn causes the snowball to pick up more snow till the time it rolls over and over again turning it into a giant one. Similarly, compounding has a snowball effect on money. Here are three important things you should know about compounding. Let us examine with numbers to understand what compounding can do to your money:

Multiplier effect of compounding – how your money grows faster

Suppose Mr.A invests Rs.100000 at 10% for a period of 20 years. As seen in table 1, his money doubles after 8 years to over Rs.200000. But later it only takes half of the time, i.e. just an additional 4 years to triple the investment to about Rs.300000 and then 3 years to reach Rs.400000. This is the power of compounding -  how investing money makes more money for you and gains momentum to multiply faster.

Small actions carried out over a period of time yield huge results in the long run.

How starting early helps:

This is one of my favourite illustrations. Here, Mr.A starts investing Rs.50000 every year from the age of 23 at the rate of 10 per cent p.a. He stops investing after 30 but does not redeem whatever he had invested in those 8 years. On the other hand, Mr.B starts investing late from the age of 30. He invests Rs.50000 every year till the age of 64 at 10 per cent p.a. Can you guess whose corpus would be higher at 65? You will be amazed to find out from the table that Mr.A accumulated Rs.1.61 crore while Mr.B lagged behind at Rs.1.49 crore. Despite investing regularly for 35 years, Mr.B could not match Mr.A’s corpus. Although Mr.A had stopped investing after 8 years, he had the advantage of starting early. Those 8 years allowed his money time to compound and grow. That is the magic of compounding.

What happens to your investment kitty when you withdraw intermittently?

This is another interesting example showing how you lose the benefit of compounding as your regularly withdraw money from your investment kitty. As shown in Table 3, suppose, you invest Rs.35,000 annually for 25 years at 10 per cent p.a. Assuming you have not withdrawn any money during this period, your accumulated corpus comes to Rs.34 lakhs. Now taking the same example, assume that while you are investing regularly, you are also withdrawing 20 per cent of the investment value in the 5th year, 10th year and so on (Table 4). The resultant corpus accumulated after 25 years comes to Rs.19 lakh. Withdrawing just 20 per cent of the corpus every few years has reduced the compounding impact and you end up with nearly Rs.15 lakh less in your total kitty. That is a huge difference.

I am not suggesting here that you should not withdraw at all. But investments when haphazardly done lead to random withdrawals which is not good for your long-term goals. I have observed many people withdraw from their PPF/EPF accounts for no urgent reason. Plan your long-term goals thoughtfully like retirement, child education, etc and let your investments compound.

If you understand how compounding works, its multiplier effect and benefits of starting early, you will understand that there is no rocket science in creating huge wealth. Even in your 30-35 years of working life, if you made a few investment mistakes, you would still be doing fine. All you need to do is invest regularly and give your money time and the opportunity to grow. The rest will be taken care by the eighth wonder of the world – Compounding!

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