Understanding the magic of compounding

Posted: March 1, 2015 at 1:43 pm

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Napoleon Hill author of best seller Think and Grow Rich is often credited as saying that Make your money work so hard for you; so that you do not have to work for it. Various books have been written on the art and science of making money based on more or less the same principle.

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Mathematically speaking Make money work for you is called as compounding or simply compound interest. Albert Einstein was amazed by the power of compounding and called it the eighth wonder of the world.

Before we move on to identifying financial goals and how to achieve them it is important to understand the power of compounding and regular saving.

Understanding compounding

Regular saving in relatively safer financial instruments yielding moderate returns can work wonders over a long period of time. If a parent starts saving Rs 25 daily for their child from the day he or she is born for the next 25 years at a rate of 10 per cent compounded annually, they would be able to gift the child an amount of Rs 9.25 lakh on his 25th birthday. Apart from the money the amount will teach the child the advantage of savings. If he learns to save and invest in the same way as his parents and starts saving Rs 3,000 per month religiously in the same instrument earning 10 per cent compounded annually he would be able to get an amount of Rs 1.02 crore at the time of his retirement (60 years).

Compounding works wonders over longer period

Wealth cannot be accumulated overnight, like a tree it needs to be nurtured. Compounding teaches us that it does not take too much of money to save a decent amount. What is required is the discipline of regular saving and time on your side. Longer the time better will be the return.

Take the earlier example of the parent saving Rs 25 daily for a period of 25 years. In order to get the same amount in a span of five years they would have had to save Rs 400 every day. If the parents had saved Rs 150 everyday for a period of 10 years they would have been able to save around Rs 9 lakh.

Another way of looking at the above example of retirement planning is that the amount of Rs 3,000 per month saved for 35 years, from the time he starts saying to his retirement, will earn the person Rs 1.02 crore. This is equivalent to receiving Rs 34,000 per month for the next 25 years of his retired life, assuming that the entire amount of Rs 1.02 crore does not earn any more interest post his retirement. In reality the amount of Rs 1.02 crore itself will be earning an interest of Rs 10 lakh per annum if it is invested in a fixed deposit yielding 10 per cent return, which would work out to Rs 83,330 per month.

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Understanding the magic of compounding

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Written by grays |

March 1st, 2015 at 1:43 pm

Posted in Napolean Hill