I once heard this fascinating fictional tale about the power of compounding. A long time ago in India, a wise man presented a new game to a king. The game was played by taking turns moving various pieces on an eight-by-eight board. It was a masterpiece of strategy and mathematics, and the king couldn’t get enough of it. The game was called “chess”.
Impressed by the game's brilliance, the king offered to reward the inventor with anything he desired. The wise man asked for a seemingly simple payment: a single grain of rice on the first square of the chessboard, two grains on the second square, four grains on the third, and so on, doubling the amount with each successive square until they had filled all 64 squares of the chessboard.
Amused by what he considered a humble request, the king readily agreed. At first, the task seemed trivial. One grain of rice was placed on the first square, two on the second, then four on the third. By the time they had reached the eighth square, the total number of grains was 255—still manageable.
But as the grains doubled, their number grew alarmingly fast. The 15th square required more than 16 thousand grains of rice. The 25th square required over 16 million. By the 40th square, the total had surpassed one trillion grains of rice.
Before long, the king’s treasurers saw that the request was impossible. To complete all 64 squares, the amount would total more than 18 septillion grains – that’s 18 followed by 24 zeroes. This exceeded all the rice ever produced, far surpassing the kingdom's resources. The seemingly simple request proved a massive undertaking, its scale beyond comprehension.
The king, awestruck and humbled, acknowledged the wisdom of the inventor. Seeing that everyone had learned their lesson about exponential growth, the inventor withdrew his request. Instead, he requested to be a royal advisor, and the king happily accepted.
This story illustrates the incredible power of compounding in investments. Compounding is when your money grows on both your initial investment and its accumulated returns, like a snowball gathering size and speed. Like the chessboard of rice, your investments will often start small. But as time passes, they can grow massively.
In finance and investing, compounding is one of the most powerful tools for building wealth. For example, imagine investing a one-time value of P10,000 at a compounding annual return of seven percent – close to the historical average growth rate of the Philippine Stock Exchange Index. After one year, the investment will turn to P10,700 – a P700 gain.
By the second year, that P10,700 will grow to P11,499 – a P749 gain. Notice that this is larger than the first year’s P700 gain. Why? Because it’s not just your original P10,000 earning interest – the P700 gain from the previous year is also contributing.
On year 10 of compounding growth, this investment will bring in P1,286.92 of profits. By year 45, it’ll bring in P13,739.92 – a value larger than your original principal. The longer you let your money grow, the more dramatic the results.
Compounding thrives on time and consistency. The earlier you start investing, the more time your money has to grow. Even small, regular contributions can add up to significant wealth over decades. For example, an investment of just P12,000 per year – around P1,000 per month – at the same seven percent annual return would grow to more than P1.2 million in 30 years.
Delaying investments significantly reduces potential returns. Waiting just 10 years to start investing could mean hundreds of thousands of pesos less for your retirement. If we made that P12,000 per year investment for 20 instead of 30 years, we’d end with around P526,000 instead of the original P1.2 million – a reduction by more than half!
Compounding's power lies in patience and consistency. Like the grains of rice doubling square by square, small financial decisions made early and consistently can grow over time to amounts that will surprise you.
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Keith Lim writes about personal finance and making money through the stock market. He blogs at keithblim.com.