Most of us have studied the concept of compound interest back in our school days. But we never paid heed to the core importance of the same in finance. It is only when we start managing our finance as adults that we understand the importance and impact of the power of compounding. It is very significant to know how the understanding of compounding can help an investor to do wonders with his investments to plan for the important milestones of life.
This concept can be directly correlated to the Snowball effect, where one starts with a small ball of snow and it builds upon itself to form a much larger snowball as it rolls down the slope. Similarly, compounding too helps an investor to build a large corpus by starting small. This leads to what we know as Exponential Growth where both the interest and principal amount increase at an increasing rate. This article talks about the working, relation with inflation, and how to avail maximum benefit from compounding. Let’s discuss these aspects in detail.
WHAT IS POWER OF COMPOUNDING?
Compounding often called the 8th wonder of the world, is an easy mathematical phenomenon but a very powerful one because it brings in the multiplier effect. Basically, compounding is a process of earning compound interest on the invested amount. The interest earned is then reinvested which in turn also earns interest, this is termed as compound interest. The investment will thus generate earnings from not only the principal amount invested but also the subsequent interest earned over the coming tenure. However, to reap the benefit of compounding, staying invested for the long term is very important.
HOW DOES COMPOUNDING WORKS?
Compounding is a long-term investment strategy. This phenomenon requires two major things to work - time and reinvestment of earnings. The interest starts earning the moment an investor decides to reinvest the interest on a principal. Therefore, effectively converting the investments into an income-generating resource where the money works to generate wealth for the investor. If invested in the right asset class, the power of compounding has the capability to generate wonderful and astonishing returns. To understand this in a better way, let’s take an illustration.
There are two persons, Mr. A and Mr. B. Mr. A starts investing Rs 1000 at the age of 25 and Mr. B begins at 35. Assuming the rate of return on investment is 12% compounded annually for both of them. By the time they turn 50, Mr. A will have an accumulated corpus of Rs 17.9 Lakhs while Mr. B would have a mere corpus of Rs 5 lakhs only.
Therefore, this is the reason why it is always said that “the sooner you start investing, the more time you will have to reap its benefit.”
HOW LONG TO BE INVESTED TO EARN MAXIMUM BENEFIT FROM COMPOUNDING?
As discussed, the power of compounding lies in its ability to reinvest earnings on the investment. Therefore an investor must not look to withdraw returns at any point before the investment period is completed. Else, this will result in risking or limiting the growth potential of the profits through compounding. The choice of the investment period and plan should depend upon the financial goals and feasibility to invest for an individual. The farther the goal is the sooner one must start to invest so as to get enough time to accumulate the desired amount of corpus to meet the goals.
Let us take an illustration where an investor invests Rs 1 lakh every year for 5 years with 10% interest per annum compounded annually. The total investment made is Rs. 5,00,000 which will become Rs 6,71,561 at the end of the 5th year by compound interest.
On the other side, if there was no compounding then the investor would have earned up to Rs 50,000 as interest (simple interest). This difference thus provides evidence of how benefitting the power of compounding is.
INFLATION AND COMPOUND INTEREST
Inflation can be defined as an increase in the prices of goods and services over a tenure. Beating inflation is the most important aspect of every financial goal planning and it cannot be ignored. Investors cannot plan their goals without including the effect of inflation. Now the question arises where to invest. If we have a look over the conventional investment options like RDs, FDs, etc, they mostly generate suboptimal or at par returns. Like most FD interest rates have dropped significantly to a mere 5-6% p.a. on long tenure deposits which hardly beats inflation. To counter this, an investor should increase his investment amount significantly or invest for a longer time horizon which is not always feasible.
But there is a way out! Which is compound interest. This will not only beat inflation but also give desired returns as it also earns interest on the interest which puts the money at work for you.
Also Read: What is Fixed Deposit: Meaning, Interest Rates, Benefits, Risk
HOW TO REAP MAXIMUM BENEFIT FROM COMPOUND INTEREST?
1. Starting Early:
Starting early will help in generating a huge corpus as the principal along with the interest accrued will keep on compounding. As we also saw in an illustration above that how a 10-year difference can result in a huge difference in the corpus. The longer an investor remains invested in mutual funds without making any withdrawals of returns, the more the money will grow and increase exponentially over time.
2. Discipline and Patience:
To create a thriving portfolio, an investor must first define his priorities and be disciplined. Regardless of the earnings, an investor must devote some time to identify his preference and goals. An investor should not be easily encouraged to making withdrawals to hamper the growth potential of the mutual fund investment. Instead of aiming for quick returns, one must focus on giving a long run to investments so that they can grow exponentially through compounding.
3. Choosing the right asset class:
Many investors may find it complex to predominantly invest in specific mutual funds as these are to be identified with thorough research. It’s always good to reach out to an expert to consult on your mutual fund investments as investments should be done after considering your financial goals, investment horizon, and other requirements.
Nevertheless, the silver lining in mutual fund investments is that they have proved to deliver better inflation-adjusted returns in a long run all because of the power of compounding.
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