Power of Compounding
Albert Einstein said, “Power of compounding is the 8th wonder of the world”.
We all have different approaches and answers when it comes to building long-term wealth. We often do not realize that it's just us doing all the hard work and not the money. Well, most of the successful investors do just the opposite. They attribute much of their success to the “power of compounding”.
If we had a choice in front of us, whether to take $3 million in cash this very instant or a single penny that doubles in value for 31 days, what would you choose? If you have heard this before, you know you should be choosing the Penny way as that will lead you to greater wealth, yet it is so hard to have faith in this route. Why? Because it takes so much longer to see the payoff!
Let’s say you take the hard cash and your best mate goes the penny way. On day five your mate has 16 cents. You, however, have 3 million. On day ten, it's $5.12 versus your $3 million. After 20 days, your friend has only $5,243. How is your mate feeling about this? You have this big chunk of cash and your mate barely has made an average month’s salary. Now the invisible magic starts to shine. On day twenty-nine, you have got $3 million, and your mate has around $2.7 million. And it isn’t until the very last day of this 31 day long marathon, that your mate beats your way out of the race as they end up with $10,737,418.24 compared to your $3 million.
How does compound effect work in real life?
Compounding is a long-term game hence why most of the young investors and people at a young age find it hard to grasp. It is the complete opposite of “make money quick” which involves very high risks. To start seeing the magical effects of compounding, we need to start investing early.
Here is another example. Let's say there are two people both investing for retirement in 30 years of time. One starts investing $100 right away and the other one does nothing for 15 years but then invests $300 per month. Given that the investment grows 5% per year, the first investor will have spent $48,000 on their monthly contributions and the second investor will have spent $72,000. Despite having spent much less, the first investor's retirement bag would have $152,000 compared to the second investor’s $123,000.
The same formula applies for investing in properties as well. The reason why they say that property prices double every 8-10 years is because of the compound effect. If you have done your due diligence while investing in property, it will grow at the rate of 6%-8% every year which would then take an average of 10 years for the price to double.