The ABC of Investing: Always Be Compounding

One formula to rule ‘em all

There is one formula or equation in almost every subject which has a profound impact in understanding and deciphering that subject. Be it the famous E = mC2 in Special Relativity, which helps us imagine the link between mass and energy - hitherto thought to be unrelated and non-interchangeable, or the V = i*R in electronics, which pretty much sums up the entire discipline explaining the flow of current against resistance when there is a potential difference (apologies for geeking out already!). When it comes to investing and finance, that equation is that of the Compound Interest. It helps us understand the asymmetrical, unintuitive and almost magical impact of time, the quantum invested and the rate of return on our capital / portfolio value.

To understand the impact of compounding, let’s start with a question - If you were to invest an amount of INR 1 Crore today, and compound it at a rate of ~13% for 30 years, what would we end up with? A whopping 40 Cr! Make that ~17% and we would be at 100 Cr! Why have I chosen these arbitrary rates of return, well, because the BSE Sensex has returned between 13% and 17% annualized over the last 30 years, depending on when you measure it. (Around March 2020, when the Sensex was around 29.5K, the 30 year annualized returns were ~13%. Today, while I pen this article, with the Sensex at 56K levels, it would still be in that vicinity given the meteoric rise in the base during 1991-92 for reasons, I’m sure, we are all quite familiar with - Scam 1992). And this is not considering the ~1.5% annual dividend yield through this time. Why the arbitrary 30 year timeframe you ask - I’ll get to that shortly.

Anatomy of the Compound

Albert Einstein has famously said: “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn't, pays it”. Given my respect for Einstein, let’s make an attempt to understand it, by having a deeper look at the formula itself:

The “Compound” (A = Amount after compounding) is a function of 3 key factors - How much you invest, the rate at which you compound your principal, and the period for which you invest your capital.

Time is your friend, actually your BFF

If you were to compound the INR 1 Cr at a rate of 10% for 5 years, you would end up with ~1.6 Cr at the end of that period. What if you decided to keep that amount invested for 50 years (10 times the initial 5 years) - what would that amount to? Just about 117 times the amount invested!

Unfortunately we, evolved apes, have a disability visualising outcomes too much into the future, focusing on immediate gains (termed as ‘Present Bias’ in cognitive psychology); and we are not too great with visualising nonlinear outcomes in our head as well. Hence, usually we don't think too much about longer term horizons, and when we do attempt to do so, we think about it in linear terms and make ‘suitable adjustments’ to visualize outcomes. A simple way I would have thought about this question on the impact of compounding at 10% for 50 years would be - hey, simple interest of 10% on 50 years would imply a 5x return. Now, I know compounding means the simple interest earned in the previous period(s) also earns the 10% interest, so I use my guesstimation skills from B-School and apply an adjustment of 5-8x on this 5x return to account for compounding, yielding a result of 25x - 40x, being wrong only by 70% - 80%. (I have asked a few friends and colleagues to compute this, and this was broadly the approach used by them as well).

If we were to compound at a modest 10% for a period of 60 years - let's say we start when we are 30 and keep the amount invested until we are 90 (or were supposed to be 90, assuming we don't survive until then):

We would end up with 300x of what we started with

• The amount we would make in the 2nd half of this period (after turning 60 in this case) would constitute ~94% of our total earnings

• If we were to interrupt the compounding for 5 years, the corpus would be lower by 40% (189x as against 304x)

• The impact of this would be significantly more stark at a higher rate of return - for instance, 4,384x at 15% (as against the 304x at 10%) - with over 99% accruing over the send half of the period

It is no surprise therefore, that Warren Buffett has made over 95% of his wealth after the ripe age of 59 (when he was worth $3.6 Bn, as against $85 Bn when he turned 90).

There is another impact of time - it heals wounds, and reduces the impact of volatility in equities. While this is a topic unrelated to compounding, not to mention this would do injustice to our BFF! When we look at returns from equity, we are all aware that it is fraught with volatility (defined by many as risk, incorrectly in my opinion). If you invest in the Sensex Index for a day, there is a ~50% chance of you losing money, invest for a year and it comes down to ~30%, invest for 10 years, it reduces to 1%. If you had invested any amount in the BSE Sensex on any given day since the inception of the index and held it for a period of 15 years, there was a ZERO chance of you making a negative return, irrespective of how unlucky or how bad a market timer you may be! However, this is a discussion for a separate article.

R for “Right to Brag”

We obsess over getting high rates of return on our investments. There is this madness over creating ‘Alpha’, beating the index, owning multi-baggers, especially in times when most stocks have given a positive 1 year return, with a good number of them doubling over this period as well. This is not to undermine the impact of the rate of return on our investments at all, it is an undeniably important input to the compounding process. The following chart demonstrates the impact of the fickle ‘r’ on the same INR 1 Crore invested over a period of 30 years, at different rates of return.

As we see, there is an asymmetric impact of returns on portfolio values over long periods of time. For instance, the difference in value between 14% and 15% rates of return is 51x vs. 66x, leaving you ~30% richer with that 1% extra return. However, in chasing high returns we err on two fronts:

Biased as we are, we give up on rationality, and start rationalizing giving in to our emotions - thereby loading up on unnecessary risk. We follow the herd, experience FOMO, get influenced by greed and fear, and we make mistakes - all to chase the deceptive ‘alpha’. I am sure most of us can look back at situations in our investing past, where we have made impulsive, emotional decisions, which we, as rational investors, would have otherwise avoided.

Secondly, we focus on ‘bragging rights’ instead of actual returns. The high return on a stock in which we invested, or getting the ‘multi-bagger’ (where your investment more than doubles), is more of a means towards social acceptance and respect, rather than to the end of wealth creation. No one talks about stocks where they have lost a majority of their capital at social gatherings. Often, we get overjoyed with the returns from a single stock, while remaining blissfully ignorant about the impact of that on the total return of our entire portfolio. This is especially true when we get influenced by emotions and invest trying to catch multi-baggers, we lack the conviction to invest a sizable portion of our capital in such investments. Hence, while it helps with emotional comfort, it is usually quite immaterial for our portfolios.

How, then, do we overcome this emotional, FOMO driven alpha chasing behavior? - We set the right expectations. The next logical question is what is the right expectation? The answer to that is, it depends! (again, the consultant in me speaks.) It depends on your age, capital available, liabilities, dependents etc., but most importantly on your temperament. The key here is to focus on process, be it an SIP in some mutual funds or defined criteria which will be followed to select specific stocks. While this may not prevent us from experiencing these emotions, it will certainly help limit the influence of these emotions on our capital.

You reap what you sow (err.. save)

The more we save, the wealthier we become. There isn't much more to it than this. We have already seen the effects of time and rate on compounding, helping us grow our capital several times over - but it does just that - multiply the capital. Therefore, it is probably even more important to save and invest more, than try to eke out a couple of points of return. While all the examples and charts we have seen so far talk about investing capital once, most of us are probably going to invest our savings periodically based on our earnings. Every time we invest, we start a new branch of compounding with the new capital (savings), and if we view our investments this way, we need to maximize the amount we invest every time for the magic to work on this new capital.

One effective way to do that is to make boring budgets - preferably a saving budget, and what is left over is for expenses. Of course, it has to be reasonable to accommodate your actual expenses, and satisfy some of your desires (which should be budgeted as well) - be it a vacation in the Bahamas, the latest iPhone you have been drooling over, or that sweet sports bike you stare at every time you cross the showroom. However, Delayed Gratification really helps (Read: The Marshmallow Experiment). Once you have decided the amount you will invest in a particular year, stick to the plan. There will always be new products and services to buy, but adjust that within your 'spend budget' - forgo something budgeted, to get something unbudgeted. When we build in that discipline, the rewards are truly staggering.

May the Force (of Compounding) be with you

To sum it all up, save more, and hence invest more; do your homework, but act rationally, expecting reasonable returns; and let time play its role in multiplying your wealth. There isn't much more to it than this!

Lastly, while we have discussed compounding largely from the point of view of investing and growing capital, it plays a role in an inordinate number of things in our life without us realizing its impact. Be it in multidisciplinary learning - where you read incrementally everyday, and over a period of time connect the dots across different fields; in fitness - where small increments in the intensity compounds your strength; in relationships - small investments in building trust and support compound into life long bonds; in habits - where small changes lead to massive improvements; and in life itself.

While I have been an investor for over 10 years now, I have been inspired to write on this topic recently, and honestly, this is my first article. While dreaming up a number of topics to start with, I decided to write on compounding because I truly believe it has a profound impact on our wealth, and most of us underestimate its impact and some of us haven't given it a real thought at all. It has certainly played its part in my portfolio!

I hope this article sparks some of your curiosity on this topic, and converts some of you into ardent believers of the magic of compounding.

I look forward to your feedback!