Thread by @MoneyWell_

Compounding 101

Albert Einstein once said, 'Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn't, pays it.'

Here's how Compounding works
👇👇

1/Some quick definitions :

Simple interest is the interest that is paid only on the initial principal amount.

Whereas,
Compound interest is interest that is paid on the initial principal amount + the accumulated interest from prior periods.

You earn interest on your interest.

2/ Now, let's understand the incredible concept of compounding using some example :

Imagine there are two best friends - Jeff and Elon

Both of them have accumulated savings of Rs.5 lakh each. They want to invest the sum.

Hence, they start their research

3/ Jeff and Elon both decide depositing it in a bank is the safe move.

Simple Bank offers a high-yield savings account with 10% simple annual interest.

Compound Bank offers a high-yield savings account with 8% compound annual interest.

4/ Jeff deposits his sum in Simple Bank because it provides higher return.

Whereas,
Elon deposits his sum in Compound Bank because he has read Einstein's theory about compounding.

5/ Jeff's 10% simple interest will earn him Rs.50K every year (10% on Rs.5 lakh principal).

Elon's 8% compound interest will earn him Rs.40k the 1st year (8% on Rs.5 lakh principal), Rs.43.2K the 2nd year (8% on Rs.5.4 lakh), etc.

6/ Jeff earns the same interest every year.

Elon's interest amount gradually increases.

7/ After 1 year, Jeff has Rs.5,50,000 and Elon has just Rs.5,40,000

Elon waits patiently.

By year 7, Elon has leapfrogged Jeff.

By year 20, Jeff has Rs.15 lakh to Elon's Rs.23 lakh (Approx).

By year 30, he has Rs.20 lakh to Elon's Rs. 50 lakh (Approx).

8/ Still don't believe me? No problem

Here's the calculation -
Jeff's Elon's

9/ Even though the return% on Jeff's principal amount was 10%, the total interest earned by him was just Rs.15 lakh.

Whereas,
Elon's compounding at 8% return earned him a whopping Rs. 45 lakh.
That's 3x Jeff's return.

10/ The key here is that with compound interest, you receive the rate of return on both the principal and the accumulated interest.

Isn't that amazing?

11/ The same concept applies to stock market, as the returns of this year compound upon the returns from last year.

Historically, putting money in a market index fund and allowing it to compound (reinvesting dividends) was the simplest, best way to build long-term wealth.

12/ Moral of the story -
Trust Einstein. The only people creating long-term wealth are the ones who follow the concept of COMPOUNDING.
Patience & Discipline is the 🔑 for compounding to work.

13/ So that was Compounding 101! I hope you found it useful.

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