Tuesday, April 26, 2016

Miracle of Compounding

Value Investing is built almost entirely on the founding principle of the Miracle of Compounding. Real wealth is created through the power of compounding or compound effect or the principle of compound interest, and not based on the genius of the investor.

Oh, is it so?

So, what is this miracle of compounding?  Who discovered it?

This universal law, just like any other law of physics, works unfailingly.  It is as sacred and inviolable in the world of finance as Newtons laws of motion and Kepler's laws of planetary motion in physics are. Ironically, this financial law was not discovered by a financial wizard but Albert Einstein, a renowned physicist.  

Albert Einstein's Portrait
Albert Einstein
So what does the law say and mean?  If an investment grows at compound interest, without break, for a very, very long period of time, the final sum will be astronomically bigger than the initial investment. 

Further, the spectacular growth in the value of investment starts happening only at the end of the very, very long period and not at the beginning.

The practical implication for a value investor is that even a humble initial investment of say Rupees one lakh ( about US$ 1500) can multiply a hundred times into Rupees one crore (Rupees ten million or US$ 150000), which is a significant sum in India today, on the back of the miracle of compound interest. 

Here I present a graph showing the actual miracle taking shape over time.

Graph shows the power of compounding or the compounding effect.
Graph shows effect of compounding after 20 years

Here we start with a humble initial investment of Rupees one lakh or hundred thousands.  We have assumed a compound interest rate of 10% per annum, which is also very realistic in Indian conditions.  We see that over a period of 50 years, the investment grows 100 times into Rupees 10 millions or Rupees One Crore.

We also can see that line starts its dramatic, upward climb only from about 25 to 30 years onwards and not before.

Please follow the two links to compounding calculators for investments provided at the end of this post.

But, what is the normal horizon of an ordinary investor, uninitiated into value investing? About one year or may be three years and certainly not more than that.

The minimum investment horizon must be 20 - 30 years and great wealth is created over even longer investment spans of 50-75 years!

Benjamin Graham taught that an investor should make a sound investment, after thorough study, and after that should simply forget about it.  But the mind of an ordinary person is highly restless.  He or she will keep on looking at the value of the investment.  The mutual funds add to the situation by sending regular Net Asset Value (NAV) reports.  The ordinary investor develops cold feet when the NAV goes down (which is perfectly normal in the share market), and sells off the investment ( if he has not already sold it at a loss) the moment the NAV appreciates by say 10-15%.

Alas, such an investor has not given an opportunity for the law of miracle of compounding to act at all!

On the other hand value investors like Warren Buffett clearly understand how the miracle of compounding works - they know the power of compounding or the compounding effect or the principle of compound interest, and sit tight on their good investments for decades at a stretch and reap the astronomical benefits produced by the miracle of compounding.

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