By: Punam Sharma
Most of us know Warren Buffett as the world’s most famous investor. But how many of us know that Buffett has become one of the world’s richest men by using one simple secret.
“What’s that secret?” you may wonder.
Well, here is a video that will reveal that secret to you…
Buffett’s Secret – Power of Compounding
In his 1962 letter, Buffett shared the story of Queen Isabella of Spain sponsoring Christopher Columbus’s voyage in 1492 to find a “new world” at a cost of around US$ 30,000.
Buffett called it a low-compound investment, as the same money invested at 4% compounded annually would have amounted to something like US$ 2 trillion by 1962 (or 470 years later).
Then, in 1965 letter, he wrote – “…the saga of trading acumen etched into history by the Manhattan Indians when they unloaded their island to that notorious spendthrift, Peter Minuit in 1626. My understanding is that they received $24 net. For this, Minuit received 22.3 square miles which works out to about 621,688,320 square feet. While on the basis of comparable sales, it is difficult to arrive at a precise appraisal, a $20 per square foot estimate seems reasonable giving a current land value for the island of $12,433,766,400 ($12 1/2 billion). To the novice, perhaps this sounds like a decent deal
However, the Indians have only had to achieve a 6 1/2% return to obtain the last laugh on Minuit. At 6 1/2%, $24 becomes $42,105,772,800 ($42 billion) in 338 years, and if they just managed to squeeze out an extra half point to get to 7%, the present value becomes $205 billion.”
After reading this, you may wonder, “All this sounds fanciful. Who lives 300-400 years to benefit from such compounding?”
Well, you don’t need to live so much to benefit from the power of compounding.
Just 25-30 years are enough, but you need to know how to use it well.
In the above video, we showed an example of how an investor can benefit from the power of compounding in the long term.
Here is another example that will show why you must not delay in benefiting from this eighth wonder of the world.
The Case of Jai and Veeru
Let’s assume there are two young men, Jai and Veeru, who begin their careers at the age of 23.
Jai starts saving money from the very first year of his job, and invests Rs 6,000 each year for 10 years.
He earns 8% return for these 10 years, and ends up with Rs 87,000 at the end of this period (on a total investment of Rs 60,000).
Now, he stops saving any more money after these 10 years, and plans to leave whatever he has saved as it is and till he is 60 years old.
He calculates that his money, if it continues to grow at 8% per year for the next 27 years (till he is 60), will grow to around Rs 694,000.
Now, let us look at Veeru’s case.
Even as he, like Jai, starts working at the age of 23, Veeru spends his entire salary for the first 10 years and saves nothing.
On the advice of Jai, he finally starts investing when he is 33 years of age, and wants to have the same amount of money as Jai when he is 60.
He calculates that he would need to save Rs 7,950 for 27 years – from 33 years of age to 60 – to reach Rs 694,000.
Let’s see the difference now.
In total, Jai, who started investing Rs 6,000 at 23 and stopped when he was 33 but left his money to grow, had to invest Rs 60,000 out of pocket to reach Rs 694,000 at age 60.
Veeru, on the other hand, had to invest a total of Rs 214,650 (Rs 7,950 x 27) out of his pocket to reach that level.
Now the question is – Why did Jai score over Veeru with lesser money invested from his pocket?
The answer – All Jai did was start early, and let the power of compounding work its magic in the long term.
The lesson for you is simple – If you can start saving and investing your money regularly from a young age, and continue to do it sensibly, the amount of wealth you will have after 25-30 years will be huge and more than enough to meet your financial goals (like your retirement, or a child’s education and marriage).
In fact, our calculations show that if you can save just Rs 1,500 per month, and let this money compound at 12% return every year for 25 years, you will end up with around Rs 28 lac at the end of this 25-year period!
If your money can earn 15% return per annum instead of 12%, your monthly investment of Rs 1,500 that you make for 25 years, would grow to a huge Rs 49 lac!
Isn’t that amazing?
Well, before we end, here are two key lessons you must not forget when it comes to the power of compounding and how it can benefit you in the long run –
- Time and money are great friends: If you can leave you money to spend a long time with time, they can work wonders for your wealth. Just start investing as early as possible instead of waiting till you grow older and have less time to compound your money. Even a 10-year delay can cause problems for you, as we saw in the case of Veeru.
- Marginally higher rate of return creates huge difference: As you just read above, Rs 1,500 per month invested at 12% for 25 years will leave you with Rs 28 lac. Just 3% higher return, i.e., 15% for 25 years will leave you with a much higher Rs 49 lac!
That is why, if you want to invest your money for the long run, say 15-20 years, invest it in assets that have the probability of giving the highest long term returns.
One such asset class is equities or stocks.
Instead of trading in and out of stocks and mutual funds, if you can keep investing with discipline over 15-20 years, you will end up with a huge wealth.
That’s the power of compounding, and as you realize, it indeed is the eighth wonder of the world.