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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.

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