In the book, Once Upon a Wall Street, Peter Lynch, one of the most successful mutual fund managers the Wall Street has ever seen, narrates a story:
'Consider the Indians of Manhattan, who in 1625 sold all their real estate to a group of immigrants for $24 in trinkets and beads.'
'For 362 years the Indians have been the subjects of cruel jokes because of it -- but it turns out that they may have made a better deal than the buyers who got the island. At 8% interest on $24 (note: let's suspend our disbelief and assume they converted the trinkets to cash) compounded over all those years, the Indians would have built up a net worth just short $30 trillion, while the latest tax records from the Borough of Manhattan show the real estate to be worth only $28.1 billion.'
'Give Manhattan the benefit of doubt: That $28.1 billion is the assessed value, and for all anybody knows, it may be worth twice that on the open market. So Manhattan's worth $56.2 billion. Either way, the Indians could be ahead by $29 trillion and change.'
This little story shows you the power of compounding and points out the fact that the earlier you start investing the better it gets.
Let's try and understand this through an example of two friends Ram and Shyam. Both start working at the same time at the age of 23. Ram starts saving when he turns 25 and invests Rs 50,000 every year. Assuming that on this he earns a return of 10% every year, at the end of ten years, Ram has been able to accumulate Rs 8.77 lakh.
After this, due to financial constraints Ram is not able to invest Rs 50,000 every year. But at the same time he does not touch the money that he has already accumulated, hoping to live of it when he retires.
He lets the Rs 8.77 lakh grow and assuming that it continues to earn a return of 10% every year, he would have been able to accumulate around Rs 95 lakh by the time he turns 60. So the Rs 5 lakh (Rs 50,000 x 10 years) he had invested in the first ten years has grown to Rs 95 lakh: even though Ram stopped investing Rs 50,000 every year after the first ten years.
Now let's take the case of Shyam. During the first few years of his life Shyam enjoyed life spending money on all kinds of things rather than invest regularly. At the age of 35 reality suddenly dawns on him and he starts investing Rs 50,000 every year. He invests this amount every year till he turns 60, i.e. for 25 years. Assuming he also earns a return of 10% per year on his investments. At the end Shyam would have managed to accumulate Rs 54.1 lakh.
Even after investing Rs 50,000 regularly for 25 years, Shyam has managed to accumulate Rs 54.1 lakh, which is around Rs 41 lakh less in comparison to Ram. Now Ram has invested only Rs 5 lakh over the ten years he invested. In comparison, Shyam over the 25 years has invested Rs 12.5 lakh (Rs 50,000 x 25 years).
Even by investing two-and-a-half times more than Ram, Shyam has managed to build a corpus which is 43% less. This happened because Ram started investing earlier. This allowed the money to compound for a greater period of time.
Also as the corpus grows, the impact of compounding is greater. Ram as we know had managed to accumulate Rs 8.77 lakh after ten years and then he stopped investing Rs 50,000 every year, allowing the accumulated corpus to compound for 25 more.
Let's say he had allowed the corpus to compound for only 20 years more till he turned 55. If the corpus had earned a return of 10% every year, then at the end Ram would have accumulated a corpus of around Rs 59 lakh. By choosing to let his investment run for five years more, Ram managed to accumulate Rs 45 lakh more.
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