The word compounding means that the initial returns or interest that you earned on investment becomes part of the invested capital or principle. Thus, it creates a chain reaction by generating returns on the returns as long as your money remains invested in the financial instrument. As once said by Albert Einstein, “Compound interest is the eighth wonder of the world. He who understands it, earns it…he who doesn’t…pays it.”
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 now understand the power of compounding with the help of a simple example.
Suppose there are two investors NIkhil and KIran 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. Nikhil opts for interest being calculated as compound interest while Kiran opts for interest being calculated as simple interest.
After 10 years(i.e at the time of maturity), Nikhil’s invested amount becomes ₹2,59,374 and Kiran’s become ₹2,00,000. The difference here is it of ₹59,374. Because of the power of compounding, the interest that Nikhil earned in the previous period was included in interest computation for the next period. In the case of Kiran, for every period, interest was calculated on the initial principal only.
Role of Compounding in Wealth Creation
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.
For example, The growth of ₹20 lakhs over 30 years if interest paid @ 10% per annum.
| Years | 5 | 10 | 15 | 20 | 25 | 35 |
|---|---|---|---|---|---|---|
| ₹ 20 lakh grows to (Rs. Lakhs) | 32.2 | 51.8 | 83.5 | 134.54 | 216.6 | 348.9 |
| Capital Growth | 61% | 159.37% | 317.72% | 572.75% | 983.47% | 1644.94% |
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.
Time duration
The longer your money can remain uninterrupted, the more your wealth can grow with the help of compounding.
The tax rate
Tax rates and the timing of the tax, you have to pay to the government affect your 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 the 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 giving growth options. 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.
Some of the key rules of investment that helps you to get the true benefit of compounding is:
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 over time.
2. Discipline
If you wish to create a healthy portfolio, you must define your financial goals and be regular in your investments. Regardless of how little 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 do not realize that it is the long-term investments that help us gain from the concept of compounding. You will have to allow your investment to grow at its own pace without interfering with it from time to time. Years of dedicated investment on your part will render a strong and healthy lump sum capital for you in the end.
One glance at the compound interest chart and you may want to do whatever it takes to earn a higher rate of return. Higher return rates can be dangerous because higher rates of return always bring higher risk. Unless you know what you're doing, no matter how successful you are along the way, you always want to avoid the possibility of losing more than a budgeted amount of investing principle.
Benjamin Graham, known as the father of value investing, was aware of this risk when he said that more money has been lost reaching for a little extra return or yield than has been lost to speculating. He warned that it is one of the greatest temptations new investors face when building a portfolio.