The Power of Compounding- The four most powerfull words in the field of investment

Compound interest is the Eighth wonder of the world.
-Albert Einstein

The most charismatic scientist ever existed in the world said that. So it must be of some value. Does it really??

Let's do some thinking-

What is compound interest?
If you have ever put fixed deposits (FD) in the banks then the banks give some amount of money at predetermined rates extra at the end of the FD tenure, that extra money is called interest. But when the bank gives interest on interest in certain FDs it is called as compound interest.

For example we book an FD for 10k at 10% interest rate for 2 yrs then at the end of two years as per simple interest rate we will get 1k interest for first year and 1k on second year, that is total 12k. But with compound interest we will get 1k as first years interest, plus 1k as second years interest, plus 0.1k interest on the interest of first year(i.e.1k). So we will get 0.1k more in the case of compound interest.

So this means compound interest is a profitable deal. The compounding magnifies as the time goes by as we get interest on interest on interest on and on...

So indeed it is the Powerfull thing.

In real life how can we benefit from the power of compounding?
Let's think about money first.
Now a days banks does not give meaningfull interest rates. They do not provide interest rates greater than inflation rates by wide margine. Which is necessary for financial freedom.
(For those who do not know what inflation is- inflation is the reduction of value of the currency, that is if you can buy a burger now with 10 bucks, you will definitely need more than 10 bucks to buy the same burger 1 or 2 or 3 years from now. That is the inflation)

So who provides such interest rates and that too laced with the power of compounding?
Possession of real estate is one source. Generally the prices of real estate grow more than the inflation but with a small difference. But let me tell you one thing, a small difference in inflation and compounding rates can do wonders if given sufficient time. One can do the research for purchasing property on local websites, one can also get average real estate price growth rates for their region from local government data or government surveys. Also known as Compounded Annual Growth Rate(CAGR).

Note:- This CAGR (Compounded Annual Growth Rate) is a very important term if you are dealing with financial freedom or want to be rich.

There is another way too- Investing in companies which earn decent amount of profit and are able to reinvest it in to their business earning more profit. Some companies can earn incremental returns on reinvested capital.

You must be thinking investing in stocks is like gambling.

Well, I strongly disagree. If done RIGHT, it can compound your money like nothing else.

RIGHT means thinking like an owner while purchasing the shares. Thinking you are buying the company instead of just a piece of paper.

If you do not understand the balance sheets or the cash flows, you can invest in the index funds as a systematic investment plan, that is invest an amount of your monthly income which you do not need for next 5-6 years. You can easily see how much your index fund have given returns in the past for extended amount of time and get an idea about the ups and downs and average returns and what to expect.

To understand how some companies or businesses are able to compound money, let us consider a simple example-
Suppose I have a general store in which I sell soaps, every week I purchase 10 soaps from a soap manufacturer at 10 bucks each that 100 bucks total. I sell those soaps at my store at 11 bucks each. I sell all the 10 soaps in a week and get 110 bucks, profit of 10 bucks.

I keep the profit aside and repeat the same process for 10 weeks. So at the end of 10 weeks I have 100 bucks of my origional capital plus 100 bucks profit (10 bucks profit every week for 10 weeks).

So I go to the soap manufacturer and make a bargain with him that I am your regular customer for 10 weeks buying 10 soaps every week, if you can give me some discount I will buy the double quantity. So the manufacturer does his calculation and considers me a valuable and growing customer and it is also economic for him to make bigger batches of soap doing the same bargaining with his raw material suppliers, as I am doing with him.

So now he agrees a price of 9 bucks per soap.

I purchse 20 soaps now and reduce the price of soaps to 10 bucks per soap in my store. My customers now become happy with the reduced price and quickly they finish up my stock of 20 soaps in a week.

So I first started with 100 bucks of capital earning 10 bucks a week and at the end of 11th week I was employing the capital of 180 bucks and earning the profit of 20 bucks.

For earning 10 bucks initially I have to use capital of 100 bucks but to earn 10 bucks more I have to employ only 80 bucks of incremental capital.

This is how good companies can earn better returns on their incremental capital investments, and the better one get that capital from their own profit.

Such companies are the best money compounding machines.

So I hope you have understood the power of compounding works in the case of money.

Money is not the only thing where the power of compounding works. It works wherever we have multiple interdependent systems. In the above case we only thought about money to make the example easy to understand, that is money interacting with money. But in reality money also interacts with other things. Just keep it in mind. You will understand it after you read the next post.

Stay tuned. Till then have a great time..

Sumit
The POWER is when,
you use ODDS
to get EVEN..