There are two kinds of investors in this world, those who understand compounding and those who don't. Almost everyone who invests claims to understand compounding, but very few grasp its potential to grow your money in a big way.
This is because compounding produces such unintuitive results that perhaps only a few mathematically-inclined individuals can be expected to have a real feel for it. The rest of us must rely on calculations. For instance, consider in which scenario your money will grow more - at 10 per cent a year for 15 years, or at 33 per cent a year for 5 years? The answer is that the two will earn the same amount, about 4.18 times.
But first, let's define what compounding is exactly. Compound interest arises when interest is added to the principal, so that from that moment on, the interest that has been added also earns interest. This addition of interest to the principal is called compounding. For instance, suppose you put Rs 100 in the bank at a 10% interest rate compounded annually, at the end of the first year, the interest will be Rs 10. Now, in the second year, the 10% interest applies to both your initial amount and the interest earned the previous year, that is to the total amount of Rs 110. The next year, the second year's interest gets added, and so on and so on. Although we use the word 'interest', the idea of compounding applies equally to all forms of returns, not just those that are called interest.
The biggest thing to appreciate about compounding is the value of time. As your returns start earning, and then the returns on those returns start earning, the profits start piling up.
The graph below shows this clearly. The blue line starts rising slowly, but as compounding takes over, the extra time means a lot more income. Translated into a human lifetime, it means that starting to save at the age of 30 instead of 50 can mean retiring with four times the wealth. The graph shows this clearly. If one has time to learn just one thing about investing, then this should be it.
This article first appeared in February 2014.