power of compounding


It is a situation in which borrowing is difficult to repay, typically because huge interest costs generally prevent the settlement of the principal amount. In the most lucid language, a debt trap would mean getting under the burden of debt and not able to find solutions to get out of debt and become debt-free. No business has become a billionaire without the help of leverage. Leverage is not a bad thing, but if not planned very well, one could get into the trap.

Whenever a person borrows money, he has to repay the principal amount along with interest charged by the lender. Repayment of principal essentially reduces the burden of debt on the borrower. In the times of crisis, the borrowing rates go substantially high, and the borrower, more often than not, is just able to repay the interest. At the time of maturity, the borrower fails to accumulate enough funds to repay the principal amount of the loan. To avoid the default, the borrower would enter into another loan transaction with some other lender to borrow money for a short duration. This borrowed money has no further use other than the repayment of the first loan. Since the tenure of the new loan is lesser, interest rates would be substantially higher. This cycle carries on until the borrower finally finds himself in the debt trap.

To summarize, debt trap is when the borrower looks for short term loans to repay its long term loan obligations i.e. Taking a loan to repay another loan is a typical case of falling into a debt trap.

Job layoffs/loss, delay in salary credit, medical emergency etc. could be some reasons for falling into a debt trap. Such emergencies can force an individual to borrow without a plan, beyond repayment capacities and at higher interest rates and thus forced to fall into a debt trap. The major problem is that the individual is overburdened by the debt slowly and gradually as it goes unnoticed mostly.

Prevalent indicators to look for to avoid getting into a debt trap are higher EMIs and fixed expenses to the total income, excessive use of credit card for regular daily expenses, borrowing short term loan to finance another loan etc.

Another most important factor is the element of compound interest in the loan. Most of the lender offer loans based on compound interest calculation only. Compounding is considered as the 8th wonder of the world, but compounding can work against consumers who have loans and debts. For most longer duration loans, the borrower ends up paying more interest than the principal because of the effect of compounding. Borrowers should be cautious while entering into a loan agreement and understand the terms thoroughly beforehand. 

Ways to get out of debt

  1. Pay more than the EMI / minimum due amount whenever there is surplus cash left for a given month. Such practise will allow the borrower to repay part of its principal as well.
  2. Debt Snowball Method: This method allows the borrower to get rid of the debt in a planned manner. The borrower will have to make a list of all the debts and arrange them in ascending order. The borrower shall pay the minimum balances of the larger loans and shall try to clear off the loans with the lesser outstanding balance. Once the borrower pays the loan with the least balance, he shall put that extra money towards the next lowest amount of debt and so on. Such practise will allow the investor to reduce the overall interest costs as well as create a positive psychological effect by these smaller wins.
  3. Create a tighter budget to cut down on unnecessary expenses and thereby, ending up saving more every month to use it to repay the outstanding debt’s principal amount. 
  4. Changing habits and lifestyle will always call for a reduction in the unwanted expenses, thus, remaining with a surplus for that given month. 
  5. Make lumpsum principal repayments – This will reduce the future cash outflows as well the tenure of the loan, thus helping to get debt-free sooner than expected.
  6. Burning the hands into a part-time job –  It might be challenging to cut down on necessary regular expenses. Therefore, one should look to increase the total income, thus increasing the amount saved monthly. 

To summarize, Individuals can avoid falling into a debt trap by following these simple steps;

  1. Create a short term budget regularly and review it at the end of the period.
  2. Don’t over leverage.
  3. Avoid the use of credit card for regular expenses
  4. Plan for future large cash outflows in advance.

The primary objective of leveraging is that the cost of leverage is less as well as it continues to boost the liquidity. The thought process is that the future income levels will pick up in months to come and thereby, help in repayment of these debt obligations. The only fundamental calculation that is required to be made is the repayment of debt. To avoid falling into a debt trap, an individual must have a budget in place to service the debt in the future. 

“Compound interest is the 8th wonder of the world. He who understands it earns it….He who doesn’t pays it…. ” – Albert Einstein 

“My wealth has come from a combination of living in America, Some lucky genes and compound interest.”- Warren Buffet

The power of compounding is really important to understand if you want to make a lot of wealth. Warren Buffet arguably the most successful investor of all time is a great believer in the magic of compound interest. He has been preaching this for decades, which has made him a billionaire. He goes onto say that compound interest over a period of time can do extraordinary things. Take a look here for an example at Buffets net worth.

Net Worth of Warren Buffett

 The majority of his wealth has been accumulated in recent years. Going from $3.8Bn when he turned 59 to currently to a whopping $82Bn when he turned 89. This is the snowball effect. It is the rolling of a snowball down the slope on a snow-covered hillside. As it keeps rolling, the ball will pick up more snow gaining more mass, surface area and momentum as it rolls along. It is a process that starts from an initial state of small significance and builds upon itself, becoming larger. This shows the effect of compounding. 

Compound interest just means you earn interest on your interest. At a 10% a year simple interest, you earn Rs 1,000 on Rs 10,000 every year and have Rs 1,500 after 5 years. If you allow the interest to compound, that 10% compound interest gives you Rs 1610 after 5 years. It’s like you earn an extra year of interest. You don’t do anything but let your money work for you. As your money keeps working for you, it keeps gaining momentum and size. The more time it compounds, the larger it becomes. 

Now coming back to the example, If you invest at 10% compound interest for 5 years, your wealth increases by 60%. But if you invest at 10% compound interest for 50 years, your wealth increases by 11,639%. That’s a lot of wealth. All it takes is 10% and 50 years. The problem is many of us don’t have 50 years to retire. Therefore to take a larger benefit of compound interest, it is better for you to start as early as possible. 

Traditionally if you invest in stocks, you want the stock price to rise but the value of the portfolio will increase linearly to that rise in stock price, i.e if there is no compounding going on. If it’s a dividend-paying stock, you can more shares going along as you keep investing these dividends into the company. These results in compounding and those extra shares keep earning more and more money. The single biggest mistake that individuals and investors make in their life is that they don’t reap the full advantage of power of compounding. It is easy to understand this concept but very few people can actually implement it and reap its benefits.

Let’s take another example of 2 people Peter and Henry. Peter starts investing when he is 20 years old and just takes little bit of his money, locks it down and sets aside to invest it. Lets say he takes out Rs 20,000/month, which is 2,40,000/year and invests it in the stock market. Overtime he averages 10% returns post taxes. Let’s say he makes that investment till the time he is 40 years old (therefore he invested for a total of 20 years) and after that he did not invest a single rupee till he turns 65 years old. On the other hand Henry does not get started when he is 20 years old. He waits till he is 40. Let’s say he starts putting in the same amount of Rs 2,40,000/year, averages the same 10% return post tax and invests till he is 65 years old. He invests for a total of 25 years, therefore has put in more money in the system than Peter. 

At the age of 65, who do you think is doing better off? I know you know the answer, but the real question is how much better off. Peter who started earlier and quit earlier, who also invested for a lower number of years has 600% more money than Henry. At age 65, Peter has accumulated around Rs 14.89 crore, whereas Henry has accumulated around Rs 2.36 crore only (after having invested for 5 more years than Peter, the only difference being Peter started out early and let his money compound for a longer period of time).

I advise you all to start out your investment journey as early as possible to reap the benefits of compounding. To do this you can visit the Stockbasket application and buy a basket/portfolio of stocks specially made by research professionals just for you. You can choose your investment options from a variety of baskets available depending on your investment goals.

“Our favorite holding period is forever.”

Warren Buffet

How long should you hold a stock? Buffett says if you don’t feel comfortable owning a stock for 10 years, you shouldn’t own it for 10 minutes. The benefit of long term investing in stock market is unparalleled, provided that investments are made in fundamentally strong companies with a good business model, sound management and growth visibility. Staying invested in the market over the long term has historically paid off. Let’s look at these benefits.

Cost effective:

Most of the market participants blow up a huge amount of money in commission, brokerage charges and various taxes by continuous trading in stocks. The more you trade, the more charges are triggered. Long term Investors will save on all these costs as it naturally leads you to transact less often. Every rupee saved can be further added to your investment capital, which makes long term investing very powerful.

Power of compounding:

“Compounding is the eighth wonder of the world. He who understands it earns it. He who doesn’t pays it” – Albert Einstein. The element of compounding comes into play during long term investments when your investments produce earnings through dividends, stock returns etc, they get reinvested in the stock and can earn even more. The more time you’re invested in a stock, the power of compounding gets larger.  Your investments can grow exponentially over time.

For example, let’s take two people, Ram and Shyam, who have the same starting balance say Rs 1,00,000 each. They both decide to buy same investment on the exact same day and earn the same interest of 10%. They both plan to hold their investment for 30 years. Ram plans to withdraw the interest at the end of each year, while Shyam plans to reinvest the interest and let it compound. Let’s fast forward 30 years and see the difference in the potential returns. Ram who withdraws the interest, would earn Rs 10,000 per year. Over 30 years, his earnings would have amounted to Rs 3,00,000. But let’s see how much difference reinvesting would have made. As shown in the chart below, Shyam who reinvested the interest would earn, Rs 16,44,940 above his initial balance which is more than 5x of Ram. This example illustrates the power of compounding. Long term investment takes advantage of the power of compounding and maximizes your returns.

Highly effective:

Long term investing works because it makes you focus on things that really matter. Long term investors will look at the core fundamentals of the company such as growth prospects, performance, management competency, etc and not look at the day to day fluctuations in stock prices. Over the long term, price movements tend to normalize depending on the performance of the business. Historically, these factors are much effective to predict future returns.

Removes the short term volatility out of the picture: 

The stock prices may show very high volatility, i.e, fluctuations in prices in the short term but maybe growing over the long term.  These fluctuations tend to confuse the investors as emotions take over leading to rash decisions.

The stock prices never go in one direction continuously without any fluctuations. As you can see in the above chart, there are several upward and downward movements in the price, but looking at the larger picture the stock is trending upwards. Long term investing helps investors ignore these short term fluctuations.

Requires Less time:

Long-term investing requires less of your time. Your work is done when you buy a stock which you think is of high quality and will maintain its competitive advantage over the years. All you have to do is to check periodically whether the company is performing well. Trading and short term investing require one to give full time and efforts to it.

No need to time the markets:

It is very difficult for someone to predict when to enter & exit the market consistently and accurately over various businesses or market cycles. You would be much better off to stay invested in the markets. Investors who try to time the entry and exit points tend to underperform the ones who stay invested throughout.

Fulfilment of long term goals:

Are you saving up to buy a house, fund your retirement or your child’s education? Long term investment is the way to go! To prepare for a high cost future, you should cut down your current costs and invest that money for the long term. The earlier you start, the compounding effect gets larger. You must be thinking which stocks to invest in for such long periods and whether the companies will still have strong fundamentals 5-7 years down the line. StockBasket is a product that will take care of this for you. It is a basket of high quality stocks, carefully chosen by experts. It helps you stay invested for the long term, without worrying about anything else. It keeps track of the portfolio and makes time to time changes if necessary Investors can choose amongst various baskets such as ‘Retirement in 2040, ‘4x target in 10 years’ depending on their goals and investment horizon.

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