What is compound interest in investment with examples

Compound interest in investment

 One must understand how money compounds to fully understand why Sham decided to stay invested and not react to short term market movements. Compound interest is the ability of money to grow when it is reinvested in the following year.

The money is expected to grow at 20% per year for the first year. At the end of the first year, the money is expected to grow to Rs.120. There are two options at the end of the first year:

1. Along with the original principal of Rs.100, invest Rs.20 in profits
2. Withdraw the profits of Rs.20.

Rather than withdrawing the Rs.20 profit, you opt to reinvest it for the subsequent year. At the end of the second year, Rs.120 has grown to Rs.144. At the end of the third year, Rs.144 has grown to Rs.173.

If you had decided to withdraw Rs.20 profits every year, your profits at the end of 3rd year would have been just Rs. 60 if you had withdrawn Rs.20 profits every year.

The profits at the end of three years, however, are Rs.173 since you kept investing. You are generating Rs.13 or 21.7% over Rs.60 because you chose to do nothing and stayed invested. Here is what we are calling the compounding effect. Take a look at the chart below to further understand this:

The chart above shows how Rs.100 invested at 20% grows over a 10 year period. If you notice, it took almost 6 years to grow from Rs.100 to Rs.300. However, the next Rs.300 was generated in only 4 years, from the 6th to 10th year.

The compounding effect’s most interesting property is that the longer you stay invested, the harder and faster the money works for you. This is exactly why Sham decided to stay invested – to take advantage of the market’s luxury of time.

It is necessary for investors to develop a long-term mindset when making investments based on fundamental analysis.

– What is Speculator Vs Trader Vs Investor

You can pick from speculating, trading and investing as ways to participate in the market. It’s important to be clear on what kind of participant you’d like to be, as this could make a significant difference to your Profit & Loss.

We can examine a market situation and analyse how each major participant (speculator, trader, and investor) would respond. Let’s consider this example to gain a better understanding.

Here’s a scenario to consider:

As a result of high and sticky inflation, RBI has hiked interest rates four times in the past four monetary policy reviews. In the next two days, they are expected to announce their latest monetary policy stance. Corporate India would suffer a hit if interest rates were to rise – thus, corporate earnings would be adversely affected.

In this scenario, we have three participants in the market – Kunal, Varun, and Sham. Each of them views the scenario differently, and, therefore would take different actions in the market.

I will briefly discuss option contracts here, but only as an example. We will learn more about derivatives in the following modules.

Kunal: His thought process are as follows:

• There is an unsustainably high level of interest rates.
• Corporate India’s growth is hindered by high-interest rates.
• Furthermore, he believes the RBI has hiked interest rates to a record high level, and it would be very difficult for it to do so again.
• When he looks at what the popular analysts on TV are saying about the situation, he is happy to see a similarity between his thoughts and theirs.
• Unless RBI keeps interest rates flat, he concludes, the rates will be cut.
• He expects the market to rise as a result.
• In order to put his thoughts into action, he buys call options from the State Bank of India.

Varun has a slightly different take on the situation. His reasoning is as follows:

• It is wishful thinking to expect RBI to cut rates. He believes no one can predict what RBI will do.
• According to him, options contracts are trading at very high premiums due to the high volatility in the markets.
• Following RBI’s announcement, he knows from previous experience (via backtesting) that volatility is likely to drop drastically.
• In order to put his thoughts into action, he sells 5 lots of Nifty Call options and expects to square off his position just before the announcement.

Sham has a sizable portfolio of 12 stocks that he has been retaining for two or more years. While his attentiveness to the economy is noteworthy, he has no thoughts on what RBI will do. Not worrying about the policy’s consequences, Sham intends to keep his shares for the foreseeable future. Thus, with this mindset, he considers the monetary policy as a fleeting wave, and it will not affect his portfolio in a major way. In any case, he has both ample time and patience to wait it out.

In the event that the market overreacts to the RBI news and his portfolio stocks fall steeply after the announcement, Sham plans to buy more of his portfolio shares.

There is no point in worrying about what RBI decides or who makes money. It is important to identify a speculator, a trader, and an investor based on their thought process. Each man appears to have taken a market action based on a logic. Sham’s decision to do nothing is a market action in and of itself.

As Kunal appears to be highly confident of RBI’s intentions, his market actions are oriented towards a rate cut. In reality, it is impossible to predict what RBI (or for that matter any regulator) will do. It is difficult to analyse these complicated matters in a straightforward manner. It is speculation to bet on blind faith without rational reasoning backing one’s decision. Kunal appears to have done just that.

Using a plan, Varun has determined what he needs to do. If you are familiar with options, he is merely setting up a trade to take advantage of the higher options premium. As he does not care about RBI’s actions, he clearly does not speculate on them. His view is simple: volatility is high; hence premiums are attractive for options sellers. Just before RBI’s decision, he expects volatility to fall.

The trader meticulously plans all of his trades, rather than relying on mere speculation. It appears that he has thoroughly tested and evaluated his strategy based on similar situations that have occurred in the past.

Sham, the investor, appears undisturbed by what RBI is likely to do. He perceives this as a passing market disturbance with no major effect on his portfolio. However, if it did have an impact, he anticipates its recovery over time. Sham is keen on making the most of the opportunity which markets provide in terms of time. In fact, he might even buy additional stocks from his portfolio if the market overreacts. His strategy involves a long-term holding of assets rather than getting affected by short-lived fluctuations.

The purpose of this chapter is to understand why Sham, the investor, has a long-term perspective and isn’t bothered by short-term movements in the stock market.