Have you ever wished to earn more money, without putting much effort?
Or are you concerned about saving enough for retirement and your child’s education?
There is a simple way to accomplish all these things if you are willing to learn how to put your money to work for you.
It is called compounding, and it can help you exponentially grow your money over a period of time.
So, let us look everything into the power of compounding and how can you incorporate it with your investments.
What is compounding?
“Compound interest is the eighth wonder of the world. He who understands it earns it and he who doesn’t pays it.”
The word compounding means that the initial returns or interest that you earned on investment becomes part of the invested capital or principle.
Compounding takes place when the returns or interest generated on the principal amount in the first period is added back to the principal amount in order to calculate the interest for the following periods.
Thus, it creates a chain reaction by generating returns on the returns as long as your money remains invested in the financial instrument.
There are two types of interest, one is simple interest and the other one is compound interest.
Simple interest is paid only on the money you save or invest (i.e. the principle capital).
Let us understand the power of compounding with the help of a simple example.
Suppose there are two investors Ram and Shyam who are looking for opportunities to create more money with an initial investment of ₹1 lakh.
They spot an opportunity where interest can be earned @ 10% per annum and both of them decide to stay invested for a period of 10 years.
Ram opts for interest being calculated as compound interest while Shyam opts for interest being calculated as simple interest.
|Rate of Interest||10%||10%|
|Duration of Investment (in years)||10||10|
|Amount at maturity (in Rs)||₹2,59,374||₹2,00,000|
|Difference in final value (in Rs)||₹59,374|
As seen from the table above, at the end of 10 years, Ram accumulates a corpus which is ₹59,374 higher than Shyam’s corpus.
Because of the power of compounding, the interest that Ram earned in the previous period was included in interest computation for the next period.
In the case of Shyam, for every period, interest was calculated on the initial principal only.
How does compounding help in wealth accumulation?
The biggest thing that investors should appreciate in compounding is the value of the time it requires.
As your returns or interests themselves start earning, the profit on your investment starts piling up at a much faster pace.
The growth of ₹10 lakhs over 30 years if interest paid @ 10% per annum
|₹ 10 lakh grows to (Rs. Lakhs)||16.1||25.9||41.8||67.3||108.3||174.5|
|Compounding Effect (Rs. Lakhs)||6.1||9.8||15.8||25.5||41.1||66.1|
In the table above, we can see that
₹10 lakhs invested over periods of 5, 10, 15, 20, 25 and 30 years translates into maturity amounts ranging from ₹16.1 lakhs after 5 years to ₹1.745 crores after 30 years period.
The compounding effect is clearly visible as the extra amount earned in each of the 5 years is exponentially increasing from ₹6.1 lakhs in the first 5 years to ₹9.8 lakhs in the next 5 years’ time.
This increases to ₹66.1 lakhs between the 25th and the 30th year.
What investment lesson he gets from above example is that someone who saves his/her capital amount for 30 years earns over 17 times the capital compared to someone who saves for 20 years and earns only 7 times the capital and so on.
Hence, one needs to start saving as early as possible and for longer periods of time to achieve the full power of compounding in investments.
Parameters that determine the power of Compounding
Three parameters will influence the rate at which your wealth compounds.
1. Compounding rate
The interest rate you earn on your investment, i.e. the returns you earn.
If you invest in stocks, this would be your total profit from capital gains and dividends.
Suppose you invest an initial capital of ₹1 lakh for 10 years in different investment avenues at different compounding rates as shown in the table.
|Investment Avenues||Rate of Interest||Maturity Amount|
2. Time duration
The longer your money can remain uninterrupted, the more your wealth can grow with the help of compounding.
Suppose you invest an initial capital of ₹1 lakh @ 10% compounding rate for different time duration as shown in the table.
This is no different than planting a tree.
The tree is going to be bigger and bear more fruits when it is 50 years old than it was when just 20 years old.
3. The tax rate
Tax rates and timing of the tax, you have to pay to the government effect on the wealth accumulation.
You will end up with far more money if you do not have to pay taxes at all, or until the end of the compounding period rather than at the end of each year.
Applications of compounding
Compounding is extremely powerful and has immense use mostly in the domain of finance and investment.
In case of bank fixed deposits (FDs), when you let the interest accumulate throughout the duration instead of withdrawing it every month, you get a higher amount in the end.
Mutual funds, on the other hand, have been successful in making use of the compounding concept in the most effective manner.
They do so by means of giving growth option.
In this, all the profits earned by the mutual fund are reinvested in the scheme by the fund manager.
Thus, it allows a higher amount to get invested in the underlying scheme which generates a higher return than the dividend option of the mutual fund scheme.
Key rules that give you the true benefit of compounding
Here are the 3 key rules of investment that helps you to get the true benefit of compounding:
1. Starting Early
There is nothing like starting early to make the most of compounding.
If you start investing from the time you start earning, it will make a solid base for you that will enable your wealth to grow further over a period of time.
If you wish to create a healthy portfolio, it is very important that you define your financial goals and be regular in your investments.
Regardless of how less you earn, knowing what your priority is and understanding how being disciplined now would pay off later, will help you develop the habit to keep money aside for investing.
3. Be patient
A lot of us wish for quick returns and not realize that it is the long-term investments that really powerfully reap from the concept of compounding.
You will have to allow your investment to grow at its own pace without meddling with it from time to time.
Years of dedicated investment on your part will render a strong and healthy lump sum capital for you at the end.
Why people don’t take advantage of compounding?
We all cannot be financial wizards, right?
Some of us are better at sports, or at art, or at running five miles without fainting.
But natural talents and inclinations aside, there is one major life skill many of us are missing, and it is hurting us in a big way.
The impact of compound interest is important and investors must have basic knowledge of this concept to assess the returns from various investment instruments.
You just need to run some numbers to see how the power of compounding can help or destroy your investments.
The Bottom Line
Compounding simply means the interest earned on interest which leads to substantial growth in investments and savings over the course of time.
The best way to take advantage of the power of compounding is to start saving and investing wisely as early as possible.
The earlier you start investing, the greater will be the benefit of compounding.
Disclaimer: the views expressed here are of the author and do not reflect those of Groww.