Power of compounding - Views on News from Equitymaster

Helping You Build Wealth With Honest Research
Since 1996. Try Now

  • MyStocks

MEMBER'S LOGINX

     
Login Failure
   
     
   
     
 
 
 
(Please do not use this option on a public machine)
 
     
 
 
 
  Sign Up | Forgot Password?  

Power of compounding

Apr 25, 2008

As adolescents, most of us must have engaged in solving mathematical puzzles, which involved throwing cleverly framed questions at our peers and then basking in some sadistic pleasure on the mystery remaining unresolved. Quite a few of them remained entrenched in the mind, particularly the ones that on hindsight appear surprisingly simple to unravel. One such question that still lingers is "If given a chance between accepting a cheque of Rs 500 m upfront and accepting an amount at the end of a month that is nothing but a coin of Re 1 that doubles everyday for 30 days, what option would you choose?" An ordinary mortal would think, give me Rs 500 m any day, as Re 1 doubling every day for 30 days is not likely to lead to anything big. Right? Wrong! The guy is making the mistake of ignoring the power of compounding, a gift of nature that Einstein, one of the greatest minds to have walked the planet, once called the 'Eighth wonder of the world'. Indeed, a Re 1 coin doubling every day for thirty days leads to a sum little less than Rs 537 m but certainly greater than the other option of Rs 500 m.

Now, how can we use the enormous power of compounding so that it benefits us? Can it be used in investing and will it result in increased wealth? The answer is definitely in the affirmative. Perhaps, it is this very power of compounding that once led Warren Buffett to comment that only follow two rules in investing:

"Rule 1 - Do not lose money, and rule 2 - Do not forget rule no 1."

The reason the great investor said so was because if left to its own devices, compounding can work wonders for your wealth creation. However, if tampered with, it can also lead to very ordinary results. Imagine two guys 'A' and 'B'. 'A' is a bit of a risk taker and hence gets extreme results i.e., while every now and then he successfully unearths a potential multi-bagger, sometimes he also invests in stocks that erode by as much as 50% in market value. 'B' on the other hand, believes in investing in companies that grow at a stable pace, say around 20% each year.

Now if we assume that 'A' invests in a '5 bagger in 5 years' kind of a stock but sees his net worth erode by 50% in the sixth year because of a wrong investment, then at the end of sixth year, he would be left with 2.5 times the amount he started with. 'B' on the other hand with his '20% growth per year' kind of a stock will at the end of sixth year, end up with 3 times the amount he started with, a good 20% higher than 'A'.

Thus, it is for this very reason that it is important to let compounding do its work and not make investments where the chances of potential downfall are high. For if you lose money, you would have reversed the process of compounding, which is potentially more powerful and hence greatly damaging. So, next time you come across a potential multi-bagger, do not forget to estimate the potential downside of your investment before estimating the upside.

Equitymaster requests your view! Post a comment on "Power of compounding". Click here!

  

More Views on News

The Top 6 Artificial Intelligence Plays in India (Views On News)

Dec 6, 2021

Investors looking to tap into AI theme need to keep an eye on tech firm leveraging the power of AI are making things possible.

6 Penny Stocks that Rallied 1,000%+ in One Year (Views On News)

Dec 6, 2021

These penny stocks shed their penny status by surging 1,000% or more in the last one year.

6 Popular Stocks that Turned into Penny Stocks (Views On News)

Nov 27, 2021

A look at popular stocks that crashed big time and never recovered, i.e. which went from 'Multibaggers to Multibeggers'.

6 Indian Companies Betting Big on Renewal Energy (Views On News)

Dec 7, 2021

Here's the list of companies pouring in the big bucks to push India's sustainable energy industry to the next level.

Is it a Good Time to Trade OMC Stocks? (Fast Profits Daily)

Dec 7, 2021

This is how you should think about trading OMC stocks.

More Views on News

Most Popular

The Power of Compounding in Stock Market

Allow the power of compounding to work its magic on your investment portfolio.

Infosys vs TCS: Which is Better? (Views On News)

Nov 26, 2021

In the post pandemic era, the top two IT companies in India are fighting to capture the growing demand for IT.

This Multibagger Stock Zooms 20% After Dolly Khanna Buys Stake (Views On News)

Nov 24, 2021

Shares of this edible oil company zoomed over 50% in three days after ace investor bought around 1% stake.

6 Popular Stocks that Turned into Penny Stocks (Views On News)

Nov 27, 2021

A look at popular stocks that crashed big time and never recovered, i.e. which went from 'Multibaggers to Multibeggers'.

India's Top 5 Monopoly Stocks to Watch Out for (Views On News)

Nov 30, 2021

These 5 companies dominate their sectors with a huge piece of the pie.

More

Become A Smarter Investor
In Just 5 Minutes

Multibagger Stock Guide 2022
Get our special report Multibagger Stocks Guide (2022 Edition) Now!
We will never sell or rent your email id.
Please read our Terms

S&P BSE SENSEX


Dec 7, 2021 (Close)

MARKET STATS