Guide to Power of Compounding

Albert Einstein said, ‘Compound interest is the eighth wonder of the world. He who understands it, earns it, he who doesn't, pays it.’ So, the compounding effect on a regular investment of a small amount over the long term can help you to accumulate a large corpus.

Often, many individuals ignore the compounding effect on their investments, which can be one of the most important accelerators in growing their wealth and accumulating a huge corpus. And knowing how it works can help you to not only earn higher returns but also plan your life goals.

What is the power of compounding?

The power of compounding can be compared to the snowball effect where you can see a small ball of snow growing larger as it rolls down the slope. In the same way, compounding helps in increasing your savings by accumulating more returns on the interest earned on the initial principal investment.

Compounding essentially earns ‘interest on interest’, which means you will not only earn the interest on your initial investment but also earn additional interest on these earnings.

Eventually, compounding interest helps in building wealth over the years.

How does the power of compounding work in investments?

The most exciting effect of compound interest is that your investments accrue returns both on the principal amount as well as the previously earned interest. This means, compounding provides a broader base, which is added to the previous earnings at every investment cycle.

Therefore, it is important you reinvest your earnings to build wealth. You must ensure you do not withdraw your earnings before the end of the investment period. It is recommended you choose the product and the horizon based on your financial goals and investible surplus.

Here is an example to understand the power of compound interest. Let us assume you have invested INR 5 lakhs for a period of five years at an annual interest rate of 10%.

Thus, the value of your initial INR 5 lakhs at the end of five years is over INR 8 lakhs and the difference is the total capital gains earned as interest.

How to gain the maximum compounding benefits?

Here are three ways to maximize your gains from compound interest.

Begin early

When you start your investments early, you can stay invested for a longer period. The longer you stay invested, the more time will your money have to multiply, thereby helping in accumulating a significant corpus over the years.

Additionally, the longer your investment horizon, the lesser will be the amount you need to save to build a huge fund.

Make wise investment decisions

Multiple financial instruments are available. It is recommended you conduct extensive research on the different products and invest in high-return products while considering your risk appetite.

Your investment decisions should help deliver an attractive real rate of return to ensure you meet your financial goals and create wealth over the years.

Grow your investments and be disciplined

Most people know that they can build more wealth when they invest a higher amount; however, this is a commonly overlooked aspect. You should ensure you save more as and when your income increases.

Additionally, invest regularly and follow discipline to create wealth. Opt for systematic investment plans (SIPs) that ensure a particular amount is invested in your chosen product at periodic intervals.

How to calculate compounding benefits of any investments

There are several investment options that offer compound interest on the principal amount. Generally, these financial products have a predetermined compounding period, such as annually, quarterly, monthly, and in some cases even daily.

The formula to calculate compound interest is A = P x (1 + r/n) ^ (n x t)

Where:

A is the maturity amount,

P is the principal amount,

R is the interest rate per annum,

N is the number of times interest is compounded,

T is the investment period.

Here is an example to understand what the power of compounding is. Assume that you invest INR 1 lakh at an annual interest rate of 10% for five years and the interest is compounded quarterly. Using the above formula, the maturity amount is as follows:

A = 1,00,000 x (1+0.10/12) ^ (12 x 5) = INR 164530

Now, if you had invested INR 1 lakh in an instrument that offered 10% simple interest for five years, the accumulated amount at the end of the investment period would be only INR 1.50 lakhs.

Therefore, compound interest investments help you build more wealth over the long term. Further, manual calculations may be tedious; so, you may use online calculators to estimate the power of compounding in a jiffy.

Power of compounding in mutual funds

As discussed, compounding can help in wealth creation when you invest a certain amount at regular intervals. But you may be wondering where to invest this money. The answer is in mutual funds via SIPs.

You may invest a fixed amount at a certain interval, such as monthly, quarterly, bi-annually, or annually in your chosen mutual funds with compound interest option.

Based on your financial goals, risk appetite, and investment horizon, you may consider investing in equity schemes to meet retirement needs as such funds can potentially deliver higher returns over the long term.

Your SIP investments can grow exponentially over the years. You may use an online mutual fund compound interest calculator to determine how much your money can grow over your desired investment horizon.

If you invest INR 10,000 per month for a period of 30 years at an expected return on investment of 15% per year, the total investment will be INR 36 lakhs.

The total estimated returns will be approximately INR 6.65 crores, which shows the potential effect of mutual fund compounding.

How to increase your savings by using the power of compounding?

To increase your savings, it is advisable to opt for shorter compounding intervals. A shorter interval increases the impact of compounding, thereby allowing you to build a sizeable corpus.

Direct equities or equity mutual funds can deliver higher returns but these products are subject to market volatility. If you are a risk-averse investor, consider putting money in fixed-income securities like debt funds, National Pension System (NPS), fixed deposits, and others.

Basic rules of investing everyone should be aware of

One of the basic rules of investing is to increase the investment amount to earn higher returns. If you have a limited income, you should look for ways to increase the investible surplus by reducing your expenses.

Determine a budget and identify ways in which you can reduce the expenditure.

Another rule is to be patient and not look for quick ways to make high returns. Chasing quick returns can lead to expensive mistakes.

Compounding works best when you stay invested for the long term and let your money work for you to build a sizeable corpus over the years.

Frequently Asked Questions (FAQs)

What is the power of compounding?

With compounding, your returns on the initial investment are reinvested to earn additional income. As a result, you can build wealth over the years.

How can you maximize the benefits of compounding?

To maximize the benefits of compounding, it is recommended to start early, adopt a disciplined approach to saving and investing, and be patient to give your investments sufficient time to build a large corpus.

Is daily or monthly compounding more beneficial?

Monthly compounding means that the interest is calculated and reinvested every month whereas in daily compounding, it is calculated and reinvested every day.

The basic principle of compounding suggests that the shorter the frequency of compounding, the higher will be the returns. Therefore, daily compounding is more beneficial than monthly compounding.