Jeff Bezos, Bill Gates, Warren Buffett, Bernard Arnault...What comes to your mind when you hear these names? For starters, the fact that they are all billionaires and among the richest individuals in the world. Besides the mammoth capital that they have, there is another factor that links them all – the principle of Compounding. Harnessing the power of compounding patiently and regularly is the key to accumulating wealth over time, writes Mehak Sood.
What is Compounding and Why is it Important?
What happens when you push a small snowball down a hill? It gradually and continuously picks up snow. When it reaches the bottom of the hill, it no longer remains the same small snowball; rather, it is now a giant snow boulder. The snowball effect is a metaphor for compounding. It explains how small actions carried out over time can lead to big results. Compounding involves the concept of earning returns not only on your original savings but also on the interest accumulated on your principal. This is a theory that is as simple in its definition as it is colossal in its impact.
Albert Einstein referred to compounding as the eighth wonder of the world. Consider the Magic Penny scenario described by Darren Hardy in his book The Compound Effect. You are given two choices: you can get $3 million today or a penny that doubles in value every day for 31 days. Which one would one choose? The majority would choose the $3 million. But if you are aware of the power of compounding then you would choose the penny. Why? After 31 days, the penny would be worth $5.3 million!
Compounding can turn a small investment into a large corpus, but time is of the essence. One should start investing early. Small amounts invested early make a huge impact in the next 20-30 years. Many investors procrastinate thinking that they will compensate for the lost time by investing large amounts later in life, which is an impossible ordeal since they will lose the impact of compounding.
Let’s take the case of two good friends Mohit and Rohit. Mohit starts investing Rs 5000 per month at the age of 25. On the other hand, Rohit starts investing Rs 7,000 per month at the age of 35. At the age of 60, both would have invested Rs 21 lakh. Assuming their investments have grown at the rate of 15%, Mohit would accumulate Rs 7.3 crore while Rohit would have only Rs 2.3 crore. Mohit has gained 69% more money than Rohit even though the latter invested Rs 2,000 more per month than him. Therefore, starting early (and investing regularly) gives a huge boost to the accumulations of corpus.
George Soros, the ‘Man Who Broke the Bank of England’, started investing at an early age. He rose from a humble background. With his consistent efforts and regular investing, he became a billionaire in a short span of time. In 1967, at the age of 37, he started his first offshore fund, the First Eagle Fund, with a capital of $12 million and he grew it to $25 billion by 2018.
Compounding Prerequisite #1
The key to leverage the power of compounding is to stay invested for a long time. The longer your time frame, the more compounding works at an accelerated rate. For instance, let’s say you have to build a stairway to reach the moon. Imagine you start with one step on the first day and double your steps daily. How long do you think it would take for you to reach the moon? It would take you just 31 days to cross the moon with a stairway length of 6.5 lakh km. However if you stop after 15 days, you would have covered only 10 km. The difference, as can be seen, is staggering.
Compounding Prerequisite #2
Another prerequisite for compounding is patience. Warren Buffett, with an estimated net worth of $81.6 billion, is indisputably one of the most successful investors in history. At the tender age of 11, Buffett bought his first stock. He bought three shares of City Service at $38.25 each and sold them quickly making a small profit of just $2. The shares later went to top $200 and this taught him the value of patience in compounding. The ‘Oracle of Omaha’ preached this principle ever since.
The Billionaire Plan
Accumulating wealth in the billions is a fantasy for all. As near-to-impossible as it may sound, let us do the math and see how realistic this is. On average, one has a financial career of 30-40 years. Let’s say you start at the age of 25 and manage to save Rs 10 lakh. If your money doubles every three years, then in a 30-year career there would be 10 doubles. Thus, at the age of 55 years, the Rs 10 lakh will have compounded to Rs 100 crore. This makes you a billionaire and puts you among the richest 1% of the people! You may say that this sounds hysterical but the mathematics is solid.
Compounding is all about starting early, building regularly, and not withdrawing your efforts halfway. These are the only three steps in ‘The Billionaire Plan’. Following these steps and the ideologies of compounding can stop no one from becoming the next billionaire.
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