The Power of Compounding!!

 “Compound interest is the eighth wonder of the world. He who understands it, earns it, he who doesn't, pays it.” -  Albert Einstein

In my last post, I explained how two persons, one starting saving just 1000 per month at the age of 21 and other starts saving at the age of 22, would have a difference of more than 3.8 Lakh in their net worth at the time of retirement. That 12000 not saved earlier would become 3.8 Lakh at the time of retirement. This is the power of compounding. 

Compounding means, that the interest you receive on your investment/ saving today keeps on adding to your savings and investment for the future years, and hence the money keeps on growing exponentially. A simple chart on how FD investment of 1000 would grow over the next years -:

As you can see, the amount 1000 grows to about 3400 in the first 15 years, and then more than 14 times at the end of 30 years. The amount grows exponentially during the last years.

This is just assuming that a person has invested only 1000 during the start and then nothing after that. 

To give a real understanding on this, let’s assume there are four people who start investing as follows. Assume that all of them invest in the same bank with a rate of interest of 9% and all of them are 25 years of age, retiring at the age of 60.

1) Akash ( A disciplined investor) – As soon as he gets a job at the age of 25, he starts saving Rs. 3000 every month and saves upto his retirement (For next 35 years).

2) Amar – He starts working, but thinks it’s too early to save, so he does not saves anything. At the age of 35, he realizes that he should start now, and starts saving double than Akash ie Rs 6000 for the next 25 years.

3) Ashish (A late investor) – He’s a person who does not invest anything, until he realizes it too late. So, in order to make up for it, he starts investing 30000 per month when he’s 50 years of age for the next 10 years.

4) Ajay  (A smart and disciplined investor) – He’s the smartest of all. He thinks to save as much he can for next 15 years, and then stop investing since he’s in a phase of his life when he’s married and the kids going to school, and he also wants to spend money on himself. So, he saves Rs. 6000 per month only for the next 15 years (up to age of 40) and then stop investing anything, but does not touches the amount he has already invested till his retirement.


Who do you think is the most intelligent person?
Let us see what the net worth of each person will be when they retire at the age of 60.

Akash – Saves 3000 per month for next 35 years – 87,43,353 (87 Lakh)
Amar – Saves 6000 per month for next 25 years – 67,02,286 (67 Lakh)
Ashish – Saves 30000 per month for only next 10 years – 58,26,867 (58.2 Lakh)
Ajay – Saves 6000 per month for 15 years, which grows to 2273709 when he’s 40. Now he does not touches this and saves it in a fixed deposit for next 20 years. And he’ll have a net worth of – 1,34,83,425 (1.34 Crore) at the time of retirement.

So, you see that investing early in life rather than later makes a whopping difference at the end. This is because the interest that you get is much higher if your principle amount is huge, and the time to grow the money is also higher. The amount grows exponentially if given a chance to grow with a good time frame. 

During these calculations, I assumed the safest option of bank recurring and fixed deposits giving a interest rate of 9%. But in the real world, with investing into stocks/ mutual funds and with reasonable time frame, one could easily get a return of 12-15%.

P.S. – For all the calculations, I used excel formulas, but you can check these at the following links.

http://allbankingsolutions.com/fdcal.htm
http://www.allbankingsolutions.com/Recurring-Deposit-Calculator-India.shtml

Managing your money - 8 basic tips for starters.

For my last blog, my sister commented that she did not understand much out of it, so I thought to write another blog on “Money Management” for the next generation, who’ll be entering into the professional life pretty soon.

Couple of things here – This is a vast topic, and depends on individual interests, so there’s no way everything can be put here. I’ll try to keep this simplistic without using any jargon’s and share my learning’s and mistakes from my past.

1) Savings, the easiest way – Would you spend the money that you don’t have? You cannot. Hence, the easiest way I think to save money is to transfer it to a “dummy” account. Destroy the ATM cards for that account, do not add any payee’s for transfers. This account is for your single future need – your retirement. Transfer money to this account as soon as you get your salary, and do not touch this no matter what. Believe me, this is the easiest way to save your money and to avoid un-necessary expenses.

2) Share with the society – I heard a news recently, where a boy who could not pay his school fee from 9th thru his graduation, got into IIM because a gentleman paid his fee. Think of the joy both the kid and the person would have. Sponsoring education for 1 needy child would mean eating out 3 times a month instead of 4, or giving up movies once in a month, it just costs 1000 bucks!! Country would progress in a much higher rate if everyone is educated, and progress would mean increase in salaries!!

3) Start investing early – You may think it’s too early to start saving for retirement, when you have just entered your professional life. NOT TRUE. Here’s an example, if a person A start investing 1000 per month from the age of 21, and a person B starts investing 1000 per month at the age of 22 (investing 12000 lesser than A), the difference in net worth when they retire at the age of 60 would be a whopping 3.8 Lakh. (Source - http://www.allbankingsolutions.com/Recurring-Deposit-Calculator-India.shtml)
This is called the power of compounding. Having said this, it's never too late to start, so if you are not already doing this, start today.

(More on the power of compounding in my future posts).

4) Don’t put all the eggs in the same basket – If you are going for a holiday trip, will you put all the money in the same pocket? Every one puts money in different pockets, to avoid losing it all in case something happens. Same if true for your investments, put your saved money into all types of investing instruments – Gold, Recurring Bank Deposits, Mutual Funds, Insurance, PPF etc.  All these instruments have a different degree of risk, and have different returns. Point here is, never to keep all your “eggs” in the same basket, always diversify.
(More on diversification of your investments in my future posts).

5) Stock Investments – This is one of the easiest way to lose your money, and the fastest way to increase or earn money. But this comes with a “risk”. Until and unless you have a very good knowledge of the stock market, keep away from it. When people say this is a game of luck and a chance, they say it so because they don’t understand the workings of the stock market. Stay away from direct stock investments, until you’re really sure about it and have a good research done.  It’s not easy to get returns from stocks as a side business. You have to spend all your time, efforts and knowledge to gain out of this. Easier way is to go through the Mutual Funds, where your money will be managed by a professional, who’s knowledgeable, and paid to this.

6) Set a budget – Jot down your monthly expenses, and start tracking them. Then, set a monthly budget for each category and stick to that. You’ll be surprised to see the money you are spending that’s not really needed and being able to save and lead a more financially disciplined life.

7) Credit Cards – As soon as you start working, and have an income coming in your account every month, it’s very easy to get a credit card. And once you have a card, it’s very difficult to “not” use it. The interest rates for outstanding credit are around 38-42% per annum, and unless you pay the entire amount, the credit will keep increasing due to these interest and late payment charges. Credit cards are a great tool for spending, and saving money on spends, but only if you are disciplined enough and spend wisely.
(More on the “vicious circle of credit card debt” in my future posts)


8) Salary and Taxes – A lot of people I met, did not understand the components of their salary sheets and were happy with whatever gets deposited in the account. Understanding the salary slips and its component is the first thing you should do when you get an offer. Once you understand the components, it’ll be easier for you to save on taxes. There are a lot of components when coming to save tax, and person who’s earning more in the same company can pay lessor taxes. Of course there’s a limit up to which you can save, but make sure you are utilizing all the tax saving instruments and save maximum.