Sunday, January 21, 2018

Understanding the power of "Compounding"

Power of Compounding

According to Einstein, compounding is 8th wonder of world. Those who understand compounding acquire wealth through it; those who do not understand end up working to pay interest throughout their lives.

What is compound interest? or what is compounding?

Compounding is the mechanism of interest calculation where interest is calculated over the interest calculated for previous periods. For example If you have borrowed 1000 rupees at 10% simple interest for 2 years; at the end of second year you are liable to return 1000 rupees as principle amount and 200 rupees as interest for two years. But, if you had this loan at 10% interest but compounded annually; interest amount will be calculated differently. At the end of first year interest amount will be 100 rupees (same as simple interest). The principle amount for second year will be 1100 rupees (i.e. Rs. 1000 principle and Rs. 100 interest accrued for first year). Hence second years interest will be Rs. 110 (i.e. 10% of Rs. 1100).   

In above example, accrued interest had a difference of 10 rupees between simple interest (S.I) and compound interest (C.I).

Most of the financial products have compounding inherited into it. Though compounding frequencies varies from monthly to quarterly to half yearly and annually. Home loans have monthly compounding whereas Public Provident Fund (PPF) have annual compounding. Generally, recurring deposits with banks have quarterly compounding. Shorter the compounding frequency, more the calculated interest amount will be.

Below, we have a simulation model of 20 schemes where Internal Rate of Return (IRR) varies from 1% to 20% compounded monthly. With regular deposits spanned across 30 years (360 months) we can see how much wealth is accumulated with each options. for ease of understanding we can deem that these are 20 different recurring deposit schemes each offering monthly compounded interest rate of 1% to 20% for 360 months.

"Compounded returns" column show the future value calculated (including principle of Rs. 3,60,000 and accrued interest)

"Difference in compounded return.." column represents the increase in wealth accumulation for every 1% rise in compounding. e.g between 0% and 1% there is a difference of 59,628 rupees (i.e. 4,19,628 less 360,000 rupees). Similarly there is a difference of 73,097 between 2% and 1%. Astonishingly between 19% and 20% this difference is on a higher side of 49 lakh rupees.

Simulation model - Wealth created against regular monthly deposits
This is the power of compounding. Wonders of compounding are evident in long run. At the end of 30 years the normal scheme with 6% returns has given 10 lakhs whereas a scheme of 12% yielded almost 35 lakhs and 17% consistent return can fetch 1 crore. This is amazing!

Let's have a look at below graphs derived from above simulation data

Accumulated Wealth
With every hike in percentage the graph is heading northwards. This depicts power of compounding in a positive way.
What if you are on wrong side of compounding?

However, compounding can have negative implications as well if you are on wrong side. For example compounding of credit cards, they have 40% or higher interest rate compounded on weekly/monthly basis. They also levi 18% GST on interest. Subsequent defaults in credit card payment lead to an inferno of financial charges and interest.

Similarly, I have met people who wondered on their home loan calculations; even though they paid lakhs of rupees in initial years through disciplined EMIs they see a very small reduction in the principle amount. This is because of the ticket size of loan, where majority percentage of the EMI is serviced towards the current months interest payment towards outstanding principle amount. In initial years because of huge principle amount on home loan interest amount paid is higher as well.

Inflation is another name of compounding. Do you remember how our grandfathers recall that in their childhood how entire household groceries were procured in few rupees. With the same compounding effect inflation has grown as well and degraded purchasing power of rupee. Hence, if we have an inflation of 6%; a fixed deposit at 7.5% is actually going to appreciate your wealth by 1.5% only (In real terms)

Inflation is the compounding in reverse direction. I.e. above inflation graph flipped down as below

Concluding Remarks
We are approached by marketeers for different financial products. You should have a thorough analysis of these products from compounding perspective. There should be a comparison on alternative options before investing. Generally, low interest options come with a guarantee or stability or consistency of returns e.g bank fixed deposits. Whereas, high interest is labelled for riskier and inconsistent options like equity or crypto currencies. They could have windfall gains, could also have a nose dive in its value. 

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