Compound Interest- The 8th wonder of the world (How to use the low-cost approach to extraordinary wealth)

Compound Interest- The 8th wonder of the world (How to use the low-cost approach to extraordinary wealth)

10,504 Comments

25th July 2021

“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” ~ Albert Einstein         

The greatest catalyst in creating wealth has already been invented. Most people even know about it, yet most would tend to ignore its mammoth effect on one’s financial life. Compound interest might be the only friend you need in your journey to accumulate wealth.

Don’t trust me, worry not. The examples and data below will make this much clearer and easier to understand.

What is compound interest?

In simple terms, Compound interest is basically the interest that is earned on interest. This “interest on interest” is where the compounding part comes in.

For example: – You invest $1000 at 10% interest, at the end of the year you will have $1100.

 This $1100 at 10% interest at the end of the second year will give you $1210.

So, in the second year your principal=$1000 has earned you interest of $100 + “interest on interest” has earned you $10.

See when this effect is applied to a decent corpus of money, over a good 2 decades or more, you end up with what people like to call generational wealth, the kind of money you pass on to your kids, and so on.

Do not worry, you don’t need to know any kind of formulae or graphs to learn about compound interest. As long as it is working in your favour, that’s all we need.

How do you make compound interest work for you?

A low-cost, simple way to create decent wealth, provided you give compounding its time is exactly what is needed.

Let’s look at an example: –

You pick an index fund as your tool to invest in equities for the below examples. They are low-cost and passively managed (the fund manager’s objective is to stay as close to the performance of an index such as the NIFTY50).

Case 1: – You do a lump sum investment of ₹5,00,000 at a moderate rate of return on your investment of 12% over a period of 20 years.

 

At the end of 20 years, you would have earned close to 50 lakhs at a mere investment of 5 lakhs, while paying very low fee on the index fund.

NOTE: – Something to keep in mind, most people don’t invest for 2 decades or so, when interrupted the compounding process will not be as effective as it can be.

If you had pulled out your money in half the time at the 10-year point, you would have accumulated just 15,52,924 losing out on the compounding effect.

Case 2: – You do a monthly SIP ( low-cost approach to extraordinary wealth) 

Now, this is how you make big money, say, you do a monthly SIP of ₹ 5,000, at a moderate rate of return on your investment of 12% over a period of 20 years.

But here is the catch, instead of investing the same amount, as your income grows so should your investment, you top up your SIP 10% every year.

 

You would have accumulated close to 1crore, ₹92, 18,564 to be exact.

But if you had interrupted the process in the initial years, you would have been left with a whole lot less money to put it simply.

This is the low-cost approach to extraordinary wealth. All it takes is time and the magic of compounding.

Of course, there are capital gain taxes to be considered and the expense that is paid on your mutual fund should also be taken into consideration (in the case of an index fund this is very minimal in the range of 0.1-0.5%).

Summing Up

 The low-cost approach to extraordinary wealth is simple yet effective, anyone can follow this method to get wealthy. But while it may look easy, in practice it doesn’t pan out so.

The limiting factor often ends up being a lack of patience and FOMO, thus interrupting the compounding cycle of wealth.  

10,504 thoughts on “Compound Interest- The 8th wonder of the world (How to use the low-cost approach to extraordinary wealth)”

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