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Nivesh Jaagran How to explain compounding to your client’s kids?

How to explain compounding to your client’s kids?

Simple ideas to explain why compounding is called the eighth wonder of the world.
Shreeta Rege Sep 9, 2018

When I was a young kid, I remember reading a story of a wealthy miser who wanted someone to count all his wealth. However, he did not want to pay anyone too much money for the errand. So when a young girl approached him with a proposition,  he readily accepted it. What was her proposition, you may ask?  She told the miser that she would count all his money. He would have to pay her just one rupee on the first day and double the payment next day and so on. To summarise, he would pay her 1 rupee on first day, 2 rupees on second day, 4 rupees on third day and 16 rupees on fourth day and so on. In the initial few days the miser congratulated himself on finding such cheap labour but as the days progressed the miser saw his wealth depleting.

In fact, on the twenty-fourth day, the girl had counted his entire corpus of Rs. 1.5 crore and now it all belonged to her.  How did this happen? This is nothing but the power of compounding.

Showing a quick calculation:

Day

Amount paid (Rs.)

Day 1

1

Day 2

2

Day 3

4

Day 4

8

Day 5

16

Day 6

32

Day 7

64

Day 8

128

Day 9

256

Day 10

512

Day 11

1024

Day 12

2048

Day 13

4096

Day 14

8192

Day 15

16384

Day 16

32768

Day 17

65536

Day 18

131072

Day 19

262144

Day 20

524288

Day 21

1048576

Day 22

2097152

Day 23

4194304

Day 24

8388608

 

You can use a similar example to help your clients’ children understand the concept of compounding. You can call it the ‘8-week experiment’. On the first Monday your client can give his child Rs. 10 and ask him to hold on to it. The next Monday your client can give him additional Rs. 10 and again asks him to hold the total amount of Rs. 20 for another week. Basically for the next seven weeks, your client can doubles the amount held by his son. 

As your client’s child sees his earnings increase, you can explain to him the concept of compounding. You can tell him that if there would have been no compounding his father would have just paid him Rs. 10 every week for the next seven weeks. This is nothing but simple interest where interest is paid only on the initial amount. If his father would have paid him money using simple interest he would have earned Rs. 80 after eight weeks.

However, due to compounding his father doubles the amount he has earned the previous week along with the initial Rs. 10. This earning interest on previously earned interest is nothing but compounding. Thanks to compounding he earned Rs.2,550 after eight weeks.

You can also use this as a chance to explain the importance of long term investing to your client’s child. With the help of illustration given below, you can demonstrate to him how even spending Rs. 5 every week instead of holding on to the money would have reduced the final amount dramatically. Instead of Rs. 2,550 he would earn just Rs. 80.

Importance of long –term investing

If the kid does not use any money

Day 1

10

Day 2

20

Day 3

40

Day 4

80

Day 5

160

Day 6

320

Day 7

640

Day 8

1280

Total over 8 days

2550

 

If the kid spends Rs. 5 every week

Day 1

10

 Day 2

10

 Day 3

10

 Day 4

10

 Day 5

10

 Day 6

10

 Day 7

10

 Day 8

10

 Total over 8 days

80

(As 10-5 = 5, 5x2 =10)

This practical lesson will help your client’s kid easily understand the concept of compounding and long term investing.

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