Wealth Creation Formula

Albert Einstein

The great 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.”

How much wealth you will create in your life is a function of 3 things

• A - Amount of money you invest from your side

• R - Where you invest (basically the return you get)

• N - How long you invest (how well you let it compound)

As an investor, the wealth creation process is very simple .. At every point of your investing life, all you have to do is take actions which maximizes A , R and finally N.

A - Amount you invest

Most of the investors chase returns, but forget to focus on A.

Just because you have got super returns on a small part of your portfolio , it does not mean that your wealth creation is happening. 

A major part of your portfolio should be into those avenues which is giving you big returns, but we observe that people are stuck into Endowment policies and bank FD's all their life which product below inflation returns.

Also, you need to push yourself and take out a sizable portion of your take home pay for investing each month. Unless you do that, you will not create major wealth. Amount you invest is like the raw material of the final product (wealth) and you have to maximize it.

Is there someone at your end (your friend or an advisor) who is helping to you consistently invest and make sure you dont over spend your income and focus on A from time to time.

Is there someone to keep a check on how much you need to invest for your goals and if its sufficient enough?

R - Return you Get

Again, how much return you get on your investment is another thing to focus on. Just because you are investing good amount, does not mean it will lead to big wealth because you also need to see how well its growing and how is the quality of that growth. 

A small difference of 2% in return over long term can mean 2X of Wealth at the end.

You need to ask yourself if your portfolio is growing at a return which above inflation? Do you know what is the R of your overall portfolio?  

How well you choose your investments will define your R .

Do you have someone trusted and experienced person on your side who is doing it for you? If you think just picking some funds on the basis of an internet articles will lead to wealth creation, then everyone will become wealthy, and you know its not possible !

N - How long are you invested

This is another main ingrediant of wealth creation.

Just because you got 20% return last year does not mean much from long term wealth creation point of you. If your 50,000 has become 1 lac in just a matter of 2 yrs, its luck and a small pocket money, but wealth creation happens when your 1 lac of investment turns out of to Rs 28 crores over years.

Compound Interest   

Compound interest means getting a return on your money... and then reinvesting the return, so that your balance will keep increasing at an ever-increasing rate. (Hence the analogy to the rolling snowball: the bigger it is, the faster it keeps getting even bigger.)

The formula for compound interest is :- 

Future Value   =   P (1  +  r / n)^Yn

where P is the starting principal, r is the annual interest rate, Y is the number of years invested, and n is the number of compounding periods per year.

Growth by Multiplication

Compound interest results in geometric growth (= growth by multiplication), as opposed to arithmetic growth (= growth by addition). You can see that in the formula: after each compounding period, the balance increases by a factor of (1 + r/n).

Let's take an example with some numbers in it: Rs1000, invested at 5%, compounded annually.

Balance ( INR ):	1000.00	1050.00	1102.50	1157.63	1215.51	1276.29
Years:	0	1	2	3	4	5

Each time you add 1 to years, the balance gets multiplied by 1.05.

Reasons why Compounding Interest is the 8th Wonder of the World

This is one investment principle which makes money making simple. There are two facets of power of compounding which if you follow as an investor, creating wealth becomes easy. First is to start investing early and giving time to your investment and second stay invested, do not withdraw money in between and let it grow.

In simple terms compounding is nothing but reinvestment of interest/income earned at the same rate so that interest/income earned also generates additional return at the same rate in future. Let me explain this with simple example :
If you invested Rs. 1,000/- in an instrument giving 10% return in a year. At the end of year 1, value will go to Rs. 1,100 and in year 2 you will earn return on Rs. 1,100 and not on original investment of Rs. 1,000/-.

So there are two simple logic of generating compounding impact on your portfolio:

1. Start investing early in life. No matter how small that investment is but start investing whatever small amount you can save. Ideally starting point should be 1st month of pay cheque of your life. So as soon as one starts earning, he/she should start investing.

2. Let your investment grow consistently without doing unnecessary withdrawals in between.

The same logic of compounding applies to retail investors approach. No matter how small you start with, important is to start investing early so that your money gets time to compound over a period of time. As investor starts early and has time on his side, he can look at higher return potential asset class like equity to generate positive real return and create wealth over a period of time. Important is not how much you invest, more important is for how long you stay invested.

Rule of 72 might help you in understanding this concept. Rule of 72 gives you doubling period. In short it explains how long your investment will take to double. This rule says that to know doubling period you divide compound rate of return into 72 and you get doubling period in number of years. e.g. if your investment generates 12% return then 72/12 = 6 is the number of years require to double your money.

So if you park your money in fixed deposit giving 9% return you will require 72/9 = 8 years to double your money whereas if you park your money in mutual funds generating 15% return you can double your money in 4.8 years.

Investment of Rs. 1 lakh will grow above Rs. 2 lakh by 5th year at 15% compounding while it takes 8 years in compounding at 9%.

As Albert Einstein said, 'compounding is something one who understands earns it and one who doesn't understand pays it'. Remember compounding works best with equity asset. That may be the reason why world's richest men list include people who have created wealth by taking advantage of compounding with their equity investment.

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