When we hear success stories in Share Market, we normally appreciate only the Stock-picking skills of that Investor. We don’t give them enough credit for their discipline and patience. Those who don’t believe in the power of Share market rubbish it calling gambling. If you will tell them about an Investor who has a portfolio worth more than Market capital of Small Cap companies, they will argue that either that Investor is born with a silver spoon or simply he might have started with huge Investment Capital. We can’t actually blame them. They don’t know about the most important concept of Financial Market ‘compounding’ and the most widely known phenomena of creating wealth – the Magic of compounding.
To know the importance of the power of compound interest one should first learn the concept of ‘time value of money’. Time value of money is the greater benefit of receiving money now rather than later. It is founded on time preference. When I was in school I bought bus Ticket from my home to School in 50 Paise. Now to travel the same distance, I have to take the BEST bus ticket of Rs. 10. Even a layman knows a term for it – ‘Mehengai’ or ‘inflation’. But it is not only about ‘inflation rate’ alone. It is also because of ‘time value of money’. Time value explains why interest is earned or paid.
FV = PV (1+r)
I am sure you have come across this formula several times in life. Yes, it is the easiest formula to calculate the future value of money from its present value. here ‘r’ is obviously the rate of interest. This formula explains to us why one should Invest in avenues which can give returns with higher interest rates than the inflation rate. We also pay taxes on our Income, brokerages on our buying and selling of Equities. We must obviously consider them as our cost on Investment too. If your returns on investments are more than the factors discussed, then only we will call them ‘real return’.
You don’t have to lose your heart after reading about how hard it is to earn from Share Market. Yes, for short term investors it is very difficult to earn good sizable and respectable returns from the share market. But it is very easy for long term Investors to do so thanks to the Magic of Compounding.
“Compound Interest is the eighth wonder of the world. He who understands it earns it and who doesn’t pay it.” – Albert Einstein
The phenomena of making returns on returns is called as power of compounding. In long term we see exponential growth in our wealth due to magic of compounding.
The amount you invest today, Regular monthly investment, Investment period, Rate of interest on savings and compounding intervals etc. are the key parameters using which we can easily find what corpus we can generate in long term by systematic investments. By systematic investment, you have to invest good capital in the Portfolio of stocks you selected and then let the Compound interest play its role. We all know the simplest formula of compound interest that we all learned at school. Aren’t we?
A = P (1 + r/n)^nt
Where, A = Final Amount that will be received
P = Principal Amount (i.e. initial investment)
r = annual interest rate
n= frequency of interest rate (e.g. quarterly,half-yearly, monthly etc)
t = number of years.
Compounding means that the initial returns that you earned on your investment shouldn’t be removed as profit. It should be re-invested as ‘added capital’. Over a longer duration, compounding creates enormous wealth. Only those investors who not only understand this secret behind the magic of compounding but also implement it with lots of discipline and patients have become super-rich investors. The early you start more returns you can generate.
Now, as you too have learned the ‘Magic of compounding’, when are you stopping your short term trading to focus on becoming Long Term investor? Do let me know in the comment below.