Learn this money trick from the rich: Understand the power of compounding and discounting to grow your money

Economic Times

3 days ago

iStock Do not discount the impact of inflation on your wealth in the long run Ever wonder how financial experts work out numbers to address the personal finance queries of their clients? The two concepts—compounding and discounting—play a critical role in calculations for personal finance management. While the former helps to calculate how much the investment will grow in the future, the latter determines how much future cash flow is worth today.
Both these concepts are based on the 'time value of money,' which holds that money available today is more valuable than the same amount received in the future, due to its potential earning capacity.For example, Rs.100 received today can be invested at 7% rate and will become Rs.107 after a year.
Why these concepts matter? Factors such as income stability, spending habits, debt levels, inflation and interest rate fluctuations, and broader macroeconomic changes influence money management. Compounding and discounting aid this process by supporting budgeting, risk assessment, asset valuation, and overall financial planning.
In addition, compounding helps investors to understand the benefits of long-term investing, early savings, consistency and reinvestment gains. On the other hand, discounting assists in assessing the viability of different investment options, evaluating the impact of inflation, and estimating the fair value of assets. Instead of delving into the mathematics of compounding and discounting, we tried to demonstrate its applications by creating various scenarios.The numbers presented in Table 1 and Table 2 are calculated assuming Rs.1 is invested whereas Table 3 and 4 are also based on annual expenditures and purchasing power of Rs.1. Therefore, these numbers can be used as multipliers for determining the maturity or purchasing value of any amount. Table 5 includes absolute values that cannot be used as multipliers.Compounding: It works by adding interest back to the principal. The subsequent interest amount is then calculated on the new principal amount. By continuously reinvesting the earnings, compounding allows the value of an investment to grow at an increasing rate. The level of interest rate, time horizon, and frequency of compounding play a key role in magnifying the effect of compounding. The investments can be made lump sum (fixed deposits, National Saving Certificates) or one-time in stocks or mutual funds, or can be spread over time (recurring deposit or mutual fund SIPs). So, Rs.1 lakh invested for 5 years at 8% interest rate has a maturity value of Rs.1.47 lakh (Rs.1 lakh x 1.47), whereas the same amount if invested for 20 years will grow to Rs.4.66 lakh. The benefit of compounding becomes evident as time increases.Moreover, the interest rate also helps in accelerating the growth; however, the impact is more pronounced in the later years. For a strong compounding effect, a longer tenure and a higher interest rate are required. Table 2 helps in finding out the maturity value of periodic (monthly) investments for different tenures and interest rates. One can multiply the monthly investments to find the maturity value. For example, investment of Rs.20,000 per month at a 10% interest rate for 24 months will create a maturity value of Rs.5.29 lakh (20,000 x 26.45).The table highlights the importance of starting early investments. Even with modest returns, investors who have started investments early can create substantial wealth over time.An investor with a 10-year time horizon (120 months) and investing Rs.30,000 per month at a modest rate of 8% per annum can create Rs.54.9 lakh wealth compared to an investor that has a 5-year (60 months) time horizon. Even at a higher rate of 15%, the investor with a 5-year horizon will accumulate only Rs.26.57 lakh. Impact of inflation Inflation or the general increase in the price level can jeopardise the calculations, especially for long-term (retirement) goals. This is because higher inflation reduces the purchasing power of money and creates an income-expenditure mismatch. While the income is affected as it loses value (can purchase a lesser quantity of goods), the expenses swell due to an increase in the prices of essentials like food, fuel, healthcare, and education. A household with an annual expenditure of Rs.3 lakh a year will grow to Rs.4.44 lakh per year ( Rs.3 lakh x 1.48) after 10 years if inflation averages 4% every year. At a higher inflation rate of 5%, the annual expenses will swell to Rs.4.89 lakh after 10 years. Discounting is the inverse of compounding that translates the money receivable in the future to its present value. The rate used to convert the future money into its present value is termed the discounting rate.The concept is based on the premise that time reduces the value of money because of inflation, uncertainty, and opportunity cost (availability of investment options). Generally, the larger the time and discount rate, the lower the present value. The purchasing power of Rs.100 at 4% average inflation rate will be reduced to Rs.68 after 10 years. As one can observe, the higher inflation rate and longer time create a larger contraction in the purchasing power (or present value). Therefore, investments must grow at a rate higher than the inflation rate.The present value proves useful in retirement planning by estimating how much one needs to save to meet future goals. The numbers highlight the importance of financial discipline. A person with more years left for retirement (implying more years for investment) requires lower investment. With 30 years to retirement, an investment of Rs.2,861 is needed every month at a 12% annualised interest rate to accumulate Rs.1 crore. Comparatively, if starting 5 years later, to accumulate Rs.1 crore at a 12% rate, an investor needs to invest Rs.5,322 every month, which is 86% higher. The amount needed every month continues to swell as the investment is delayed. Fun shortcuts
Personal finance has some mental math shortcuts that help with quick calculations. Though the calculations are not exact, they provide close approximations. Some of these shortcuts:
Rule of 72This helps to calculate the number of years it will take to double the money. Simply take 72 and divide it by the interest rate. For example, at a 15% interest rate, it will take 4.8 years (or close to 5 years) to double the money.
Rule of 114 Want to know how long it will take to triple your money? Use the rule of 114. It works in the same way as the rule of 72. Simply divide 114 by your interest rate to determine how long it will take for your money to triple. At a 10% interest rate, it will take 11.4 years to triple your money.
Rule of 144 This rule provides an estimate of how long it will take to quadruple your investment. At a 10% interest rate, it will take 14.4 years for an investment to grow 4 times.You may look at Table 1 to verify these rules. The multiple is 2.01 at 5 years, indicating Rs.1 will turn into Rs.2 at the end of 5 years (approximately) at a 15% interest rate. Similarly, the multiple is 4.18 at 10% for 15 years, indicating the investment will grow 4 times in around 15 years.
Rule of 70 This is a useful rule for predicting your future buying power. The rule of 70 helps you estimate how much your money will be worth in the future. Simply divide 70 by the current inflation rate. This will tell you how long it will take for the value of the rupee to be cut in half. At 4% inflation rate, the rupee will lose half of its purchasing power in 17.5 years. This is specially important for retirement plans, as it may affect the way one chooses to set up monthly withdrawals.