Have you ever wondered why the rich keep getting richer? Why do their incomes grow at a much faster pace than everybody else? The answer: Compounding.
If building wealth were an easy path, it would be the most crowded one. There have always been secrets and skills for building wealth, and one of the biggest secrets to wealth-building is compounding. The effect of compounding comes from reinvesting your earnings from an asset to generate additional revenue over time. The more returns one reinvests, the higher the returns one will receive in the future. This snowball effect of investments keeps revenue streams stable and incremental in the longer term.
Albert Einstein is often quoted to have called compound interest the 8th wonder of the world. “He who understands it, earns it; he who doesn’t, pays it,” he is reported to have said. Although he may not have said this, the message is still apparent – to win the game of wealth, you need to understand the power of compounding to make your money make you money.
It would not be possible to talk about compounding without mentioning Warren Buffet, who is often referred to as one of the greatest investors of all time. Buffet called compounding “an investor’s best friend.” However, to fully reap the benefits of compounding, money must be invested for more extended periods; Not five years but 20, 30, or more.
Compounding can work for you as well as against you. To make it work for you, you need to make sure your income exceeds your expenses and the surplus savings invested in a profitable asset. Creating wealth over time with compounded growth is not a roll of dice game rather a scientific process, maybe even a syntax! Being financially constrained today might be your reality right now, but staying the same is a conscious decision you are making.
To fully understand how you can make compounding work for you, here’s an example:
Assuming your income and expenses grow by 10%, this is how your savings would increase over 30 years:
Investing the saving at the end of each year (at a 20% rate of return) leaves you with a portfolio that grows as follows:
This investment, after compounding does its magic, yielded returns of 73%, 171%, 562%, and 1504% over a period of 5, 10, 20, and 30 years. THAT is the magic of compounding. THAT is how wealth is created.
Note: For simplicity, this model ignores taxes and other deductibles.
However, before making an investment decision, one needs to be wary of what they’re putting their money into. Discipline, knowledge, and patience are key elements that go hand-in-hand with compounding. Measuring your expected growth and possible risks associated with it is a key step in achieving your portfolio objectives.
DAO PropTech is a digital platform that enables the masses to begin their journey towards financial freedom by carefully selecting the best real estate properties and digitally bridging the gap between buyers and sellers. On compounding, Chief Sales Officer at DAO PropTech, OwaisBarlas, says, “Speaking from personal experience, I would advise people to start early, ideally in their 20’s.” He added, “One should aim to maximize the time one holds money in the market to maximize the effect of compounding. DAO PropTech removes the worry of not having an investment big enough to start, allowing people to start their journey towards asset ownership with as little and as early as possible. The game of compounding is best learnt by playing it.”
Even if Einstein did not say so, I think it would be safe to assume that compounding indeed is the 8th wonder of the world. It is a universally applicable concept that the sooner one masters, the better.