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| The Power of Compounding |
When people invest in stock markets, there is often an expectation of huge returns. It is human tendency to see the top gaining stocks of the day/week and to see some of these stocks gain 30-40% in just a week’s time. While the possibility does exist to bag such kind of returns in the stock market, it is really rare to bag such returns on a regular basis. I was just trying to do a simple analysis to see what kind of annual returns would stand us in good stead over a substantial time frame.
Let’s consider a time frame of 20 years. What if I were to tell you that there is a way by which you could multiply your wealth by 40 times in this 20 year period? To be more clear, what I am saying is, if you invest 1 lakh rupees today, you would get back 40 lakh rupees after 20 years. Would you be interested in a proposition like this? Well, if I had an option like this, I would have happily accepted it. How many people we know can actually multiply their capital by 40 times over 20 years? Not many. Well, what might surprise you more, is that this can be achieved by just generating a consistent annual return of 20% every year through this period. Yes, I am not talking about anything spectacular like the ‘40% in 1 week’ type of returns. I am talking about obtaining 20% over a 52 week period, consistently. That is all that is needed to multiply your principal invested by 40 times in 20 years.
This is the power of compounding that I was talking about. The key factor in this is time. The returns rise dramatically with increase in time. If I were to increase the time period to 30 years, the sum invested gets multiplied by 237 times! Which means, if you just consistently get a 20% return year after year over a 30 year period, your 1 lakh invested once at the start will turn into 2.37 crores!
What is the lesson that we can draw from this? It is apparent that the key to investing is to generate steady returns 'consistently'. One need not aim for very high or unrealistic returns as it typically results in generating an erratic returns profile. For instance, consider someone getting returns as shown below:
Y1 | Y2 | Y3 | Y4 | Y5 | Amount after 5 years | |
Erratic profile returns | 80% | 10% | 40% | -25% | -5% | 1.97 lakhs |
Steady profile returns | 20% | 20% | 20% | 20% | 20% | 2.48 lakhs |
If this person were to invest 1 lakh at the start of Year 1, it would turn into 1.97 lakhs after 5 years. Now consider a scenario where this person were to get a steady 20% return over the 5 years. 1 lakh would turn into 2.48 lakhs in this case which is much higher than the first case though in that scenario the person got 80% and 40% returns in 2 of the 5 years!!
So you see the power of generating steady and consistent returns? There are no heroics needed. Just follow the old mantra – Slow and steady wins the race and leave the rest to the power of compounding. To generate steady returns, it is all the more important to have a balanced and de-risked investment portfolio with good measure of both debt as well as equity so that you can handle any macro eventualities or erratic stock market dynamics. You may refer to my earlier post on Warren Buffett principles on how to build a balanced and well thought out portfolio.
To conclude, the power of compounding can really work for us if only we recognize it and orient our strategies to exploit it to our advantage.
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