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Sunday, August 17, 2014

How powerful can compound interest be?



The other day, my 12 year daughter came to me after checking her online account, and started to discuss about the interest that was credited to her bank account. She had done some mental analysis, and wanted to understand how powerful compound interest can be?


There is hardly anyone who would not have heard about Compound Interest. But perhaps the biggest tragedy of our financial life is the extent to which we underestimate the immense power it holds. Compounding works with time leverage and has the potential to create such immense wealth, that you just cannot foresee it enough. 

Let me ask you a very simple question. Imagine holding a normal paper sheet (approx 0.1 mm thick). Try folding it in half, so as to double its thickness. Fold it once again to double its thickness further. Do this 50 times. Just assume that you can physically fold it 50 times. Now, make a guess. What would be the approximate thickness of the paper after 50 folds? Few centimeters? Few meters? No. It is higher. It is stunningly higher. The approximate thickness of a normal paper after 50 folds would be more than 112 Million Kilometers! Yes, believe me. It is true. Try using a calculator if you want. And imagine what would happen if we allowed just one more fold. We would achieve in the next one fold, what we achieved in last 50 folds.


This is how powerful compounding is, provided you give it enough time to create an impact. The only reason most people get disguised and are unable to realise its true power, is because compounding works on the concept of delayed gratification, wherein, you do not really see its impact for the major part of the tenure. But the magic happens in the last part of the tenure, wherein, it just explodes exponentially. 

To a common man, compounding has always been just some extra interest over interest. But for a smart investor, it is, as Albert Einstein described, the 8th wonder of the world.

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