Whether Einstein actually said that compound interest is the eighth wonder in the world or not, it is definitely one of the most powerful concepts you can imbibe.
The now famous example of how 1% better daily leads to a compounded “betterment” of 37 times over a year is revolutionary but also hard to act on. I mean what does 1% daily improvement even mean?
So I would rather focus on taking a long term view of compounding. Like someone rightly said – “Most people overestimate what they can achieve in a year and underestimate what they can achieve in ten years.”
Those of who are involved in some way in stock market may be more adept at applying concepts of compounding and CAGR but for those uninitiated I would strongly advise to learn and start applying.
Since I have understood the power of compounding and learnt the concept of CAGR, I regularly open up an Excel and punch in numbers and try to look at things like present value, future value, rate of return etc. I believe once you get into this habit, your perspective of looking at things completely changes.
Some fun experiments to get started on the magic of compounding:
1. Take your first drawn salary and your current salary and find out the annualised CAGR. I did this and suddenly I realised that the answer was far better than the last annual raise I received. This means, first, I need not beat myself on the last raise I got. Looking at the long term growth I have had (measured in this case in terms of CAGR), I seem to be doing fine.
2. When someone tells you a story about how their cousins uncle bought some real estate decades ago and how that had led to a ridiculous current price, do a quick CAGR. I bet there is a chance that the number you get is not something extraordinary. Getting into a habit of these quick calculations will help you in both – first is to not get overwhelmed with such stories and thinking how you missed the bus, and second is to understand that you too can make generational investments and there are enough opportunities to make such investments (ex: after all that real estate investment story might have just given returns you too could get from equity investments).
Here another thought experiment. Right now I do not live in India, but I do hear a lot of grudge from people about rising fuel prices. I am not going in the macroeconomic stuff or anything remotely political. I got my first bike in 2002 and the petrol cost then was INR 35. Today it is roughly INR 100. This is around 5% CAGR. I am not trying to justify anything, but the moment we look at things from a long term perspective we might think differently; in this case one can argue that fuel price has increased in line with inflation. And then we might start looking at other goods/commodities which have surpassed inflation trend and focus on the reason for that rather than harping on fuel rates.
An easy way to imagine progress (could be in context of personal goals or financial returns) is to understand and apply the Rule of 72. First remember that this rule is an approximation and not accurate math. In simple terms, when you divide 72 by the annual returns you expect, the answer is the number of years it will take for your input to double. So if you are expecting a 8% raise in salary, then it will “roughly” take you 9 years (72/8=9) to double your salary.
PS: Nerds will point out that when considering things like annual financial returns, we need to differentiate between nominal and real returns (aka adjusted for inflation). I agree with that. But first get the basics right, and then advance into next stage.
On life and time 