The power of compounding in building wealth


Director, Banyan Tree Advisors

December 23, 2011

One notices that man typically wants to get rich quick and the attempt to do it quick usually results in a lot of mistakes that one regrets later. Building wealth through your investments is a slow process and in our opinion can be best achieved with a long term orientation.

One of the most powerful concepts at work over the long term is the power of compounding. It is said that the native American Indians sold Manhattan to the Dutch for some beads and trinkets which were then valued at roughly $16. That seems like a trifling sum compared to an entire island which today houses some of the most expensive property in the world. While there are not too many reliable estimates for the value of all the property in Manhattan, one-back- of-the-envelope calculation put it at roughly $8 trillion in 2005. This transaction supposedly happened in 1628, which is roughly 383 years ago. Had the Indians been able to multiply their money at 8% p.a. over these years, their wealth would be equal to roughly $100 trillion, several times the value of all the property in Manhattan and roughly 6 times the US GDP in 2010. Similarly, Indian folklore talks of a Brahmin who asks the King for a grain of rice on the first square of a chess board and then double that amount in every subsequent square. The net result is that there is not enough grain in the King’s granary to satisfy the clever Brahmin. Both these anecdotes from folklore tell us about the immense power of compounding over the long term. It of course also lets us into the secret that very high rates of return can not be achieved for indefinite periods of time, but more of that some other time.

Download this excel spreadsheet that demonstrates how Rs 1 lakh would grow at different rates of return over a 20 year period. The difference in amount can be quite large over a 20 year period.

It is our belief, and this has been demonstrated over decades of experience, that the probabilities of making higher rates of return are far more with equities than with debt over long periods of time.  The Sensex Vs Other Investments excel spreadsheet compares the returns from equity and debt over the last 30 years.

The key to using the power of compounding to build wealth is the number of years that compounding can be put to work. The earlier one starts to invest, the more the likelihood that one will be able to build a reasonably large pool of wealth for one’s retirement.