Compound Interest - the strongest force in the universe!

Einstein once said: "the strongest force in the universe… Compound Interest!"
(think about it!)

A lot of us know the formula for compound interest, but few understand it and even fewer actually see the force and use it to their advantage...

Let us look at Compounding more closely…

[A rate of 30% over 5 years expands the amount to: P * 1.3 * 1.3 * 1.3 * 1.3 * 1.3 = 3.7129 P]

Have you heard the phrase: "Money making Money!"
It is all about your interest bringing more interest and henceforth (growth over growth!)

In fact, Compounded Interest is also the single biggest force that drove me into the world of Investing and have my life committed to it.

In my career as an Investor, I simply focus on these 3 parameters:

Principal
Principal is the size of your kitty.

By the very nature of compound interest, your Principal is dynamic and keeps adjusting itself with the latest value of your kitty. The role of principal is simple. Had you started out with 2 instead of 1, you would have had twice as much today.

Rate
The rate of returns is a measure of your investing intellect/aptitude. By far, the single biggest factor of focus for an investor. Nearly everything you do as an investor is oriented towards maximizing this parameter.

Theoretically, no matter how small a Principal you start with, if you have a higher rate of return, you would eventually surpass anything however big. (Alternatively, if you are driving faster (and in the right direction :)), you would overtake any vehicle however ahead, if the race is long enough)

The difference between a 10% versus a 20% return stretched over 10 years is 140%

There is a crucial role of consistency here. For instance, if you aiming for 50% annual returns and fail to get any returns for an interim year, than you need to get 125% returns to make up for it the next year. (Imagine what it would take to cover up for a loss)

Time
Time is your tenure or longevity as an investor. Starting early is one advantage, not quitting is another and living longer is yet another. If you are healthy and live 3 extra years at 26% an annum, you would die/retire twice as wealthy :)

However, compound interest is not meant for gamblers or those willing to risk the life of their investments.

Over the years, a number of very smart people have learnt the hard way that a long string of impressive numbers multiplied by a single zero equals zero

Simple Interest: Unless the interest is paid back to the investor year after year, any calculation using simple interest is wrong, rather unfair.

Time and again, I have failed to understand the application of simple interest.

The world human population grew from 1 billion to 6 billion in the last century (1900 to 2000) at 1.8% compounded rate. If it was the simple interest at work, the same 1.8% rate of "simple" growth, would have resulted in a population of just 2.8 billion instead of 6 billion. So you see, it is never "simple" when it comes of application! Moreover, simple interest here would have meant that only the first generation reproduced.

While simple interest is addition, compound interest is multiplication.
Remember: Repeated multiplication always beats repeated addition!

Coming back to compound interest, here is a chart that will help you see the potential.

These are the returns with a one time investment of $ 100 or INR 100/-
Imagine the returns if you invested more or recurring monthly/annually through SIP.

I decided to limit the chart at 50% and 50 years as I neither aspire to get anything close to 50% compounded returns nor expect to live beyond 50 years from now. Moreover, I started having trouble with numbers beyond these.

Another example: If you consistently manage to double your money every 2 years:

• An amount of $ 100 K would be approximately $ 100 Million in 20 years after 10 doublings.
• And the same $ 100 K would be approximately $ 100 Billion in 40 years after 20 doublings.

However, it would be foolish to think only math's and continuous compounding in a limited real world…

That brings me back to an excerpt from Warren Buffet's 1989 letter to the shareholders of Berkshire Hathaway... 

We face another obstacle: In a finite world, high growth rates must self-destruct. If the base from which the growth is taking place is tiny, this law may not operate for a time. But when the base balloons, the party ends: A high growth rate eventually forges its own anchor.

Carl Sagan has entertainingly described this phenomenon, musing about the destiny of bacteria that reproduce by dividing into two every 15 minutes. Says Sagan: "That means four doublings an hour, and 96 doublings a day. Although a bacterium weighs only about a trillionth of a gram, its descendants, after a day of wild asexual abandon, will collectively weigh as much as a mountain...in two days, more than the sun - and before very long, everything in the universe will be made of bacteria." Not to worry, says Sagan: Some obstacle always impedes this kind of exponential growth. "The bugs run out of food, or they poison each other, or they are shy about reproducing in public."

Coming back to the real world:
The good news is that compounding does work in the real world, even with smaller and more realistic rates of growth.

We often tend to limit our minds with the highest or the best that we have seen in the past. Think for yourself, how many times have you looked at the 'all time high' and fallen short of being able to see anything beyond... man, that's the highest it ever got to! And we draw the line…(this is like driving a car with eyes on rear view mirror!)

An old or a newer high can most certainly be a resistance (more so because we create it in our minds), but certainly not the end. These are just milestones after all.

The other day, I heard someone say…
"Man, I don’t think Dow will ever go beyond 14000 again…!"

Here is best reply, in the words of Warren Buffet:

"The Dow averaged 5.4% per year during the last century despite two world wars and a great depression. To get 5.4% of gains per year, the Dow will have to end this century around 2 million. So you better get used to announcing these little milestones"

Happy Investing and Happy Compounding!