What is the power of compounding?
Mathematically speaking, compounding is defined as, ‘the increase in the value of an investment, due to the interest earned on the principal, as well as the accumulated interest.’
Simply put, it is a strategy that makes your money work for you. It could be regarded as a powerful tool to grow your wealth. You can use the power of compounding to plan your future goals, such as retirement.
Simple interest means you earn interest on your principal. But with compound interest, you earn interest on the principal amount as well as the accumulated interest amount over successive periods. Over time, this interest snowballs into a substantial amount.
Let’s look at this example: Let us suppose that Raj invests Rs 1,00,000 at the rate of 1% interest per month, compounding each month.
The interest paid to him in the first month is Rs 1000 (1% of Rs 1,00,000).
In the second month, he will earn Rs 1,010 (1% of Rs 1,01,000, and so on and so forth).
In this case, the frequency of interest compounded will give him higher returns.
Consider the example of Geetha and Laxmi, who are both starting their careers.
From age 25, Laxmi saves Rs 5,000 a month in an SIP. It generates a return of 12% per year on average. Laxmi continues to invest this amount until the age of 55, or for 30 years, her total contribution amounting to Rs 18,00,000.
Geetha, on the other hand, is 40 when she decides she needs to make sure she has money saved for retirement. She invests Rs 10,000 a month in an SIP and also gets an average return of 12%. She is starting later than planned, but she’s certain she will catch up to Laxmi– she has 15 years until she retires.
By age 55, Geetha has invested the same amount as Laxmi — Rs 18,00,000. She has caught up!
However, because of the benefit of time – a head start of 15 years – Laxmi’s investment gives her a valuation of Rs 1.76 Crore, compared to Geetha’s valuation of Rs 50.45 lakhs! Those 15 years make a remarkable difference and illustrate the benefit of saving – and putting compound interest to work – as early as possible.
| Laxmi | Geetha | |
| Starting age of SIP | 25 | 40 |
| SIP continued till (age) | 55 | 55 |
| Total years of investment | 30 | 15 |
| SIP Installment amount (Rs.) | 5,000 | 10,000 |
| Total Investment (Rs.) | 18,00,000 | 18,00,000 |
| Valuation (Rs.) | 1,76,49,569 | 50,45,760 |
If you are in your 20s and 30s, you have time to build up a retirement nest egg – and you have a powerful friend called compound interest, which is a smart name for earning interest on interest. Even if you are already in your 30s or 40s, it is never too late to start saving for your retirement, but the younger you are when you start, the more you stand to benefit and the less money you need to put away each month compared with somebody starting to save in later years. It’s all about allowing time for your money to grow.
Power of Compounding
We have talked about the benefits of investing a fixed amount regularly to benefit from compound interest. But there is a big question to be addressed. Where can an investor put his money to achieve the full benefit of compounding?
The answer is mutual fund and Equity Investment.
Here’s how it works: You can invest a fixed sum in mutual funds regularly through a SystematicInvestment Plan (SIP). This can be monthly, quarterly or semi-annually. You can select the fund of your choice, use an SIP calculator to calculate the return on your investment and make a SIP payment on the allotted date. Investing regularly through SIPs could magnify your returns over time.
While you can invest in most fund types through a SIP, you may want to consider investing in equity funds for long-term goals like retirement planning. This is because equity funds have the potential to offer better returns in the long-term.
The best part about SIPs is that you can automate your payments by giving a standing instruction to your bank. You can transfer money from your registered bank account directly to the mutual fund on the specified date. As a result, you don’t need to worry about missing payment schedules.
Key rules to enable the power of compounding
1. Make an Early Start
As with all good things in life, you must start early with your investments to make the most out of the power of compounding. For example, if you put your money into an investment plan as soon as you start earning, you can enable your savings to grow significantly over time – courtesy the power of compounding.
At the same time, the longer you remain invested without making withdrawals from your returns, you allow your money to grow further because of the power of compounding increases exponentially over time.
With an extended investment horizon, you have time working to your advantage, and your investments have a better chance to accrue more interest.
2. Go for Shorter Intervals of Compounding to Have a Greater Impact
Another aspect of the power of compounding is the interval or frequency at which the interest multiplies. Different investment options in India offer a variety of compounding frequencies, such as on a daily, monthly, quarterly, bi-annually or annual basis.
The shorter is the interval of compounding, the more significant impact there is on your investments. For example, let Ramesh invest Rs 10,000 in two different types of investment, for an investment period of three years, while the first investment option offered a return of 7% p.a. compounded annually, the second option offered to provide the same rate of return of 7% per annum but compounded quarterly.
At the culmination of three years, the first investment option was worth Rs 12,250, while the second one was worth Rs 12,314. Therefore, you can see that shorter intervals of reinvestments provide more remarkable returns than more extended intervals.
Overall, when you increase the frequency of reinvesting (or compounding), you can see a more significant difference in your returns. Therefore, it is advisable to invest in equities if you have a long investment horizon – this way, you can avail of a better rate of return over the extended period of investment.
3. Be Patient and Disciplined
To create a robust and thriving investment portfolio, you must first define your priorities and be disciplined about your investments. Subsequently, you must look to leverage the power of compounding to maximise your investments. Regardless, of how much you are earning, you must devote some time to identify your goals and preference. Doing so will enable us to understand and leverage the benefits of long-term regular investments, and how power of compounding would come into play.
At the same time, you would not be easily enticed into making pre-mature withdrawals to jeopardize your fund’s growth potential. Instead of quick returns, you must focus on giving ample time to your investment so that they can grow into substantial wealth, courtesy power of compounding.
4. Choose the Right Instruments
Arguably, you may not have the financial acumen of a seasoned stock investor. However, you mustn’t think that power of compounding is not for you. You may find it difficult to invest in stocks predominantly, as these instruments fall under the volatile asset class and offer no guarantee of returns.
However, the silver lining in stock investments is that equity investments have proven to deliver better inflation-adjusted returns over the long-term, compared to all other investment options and asset classes.
Give Your Savings the Power of Compounding!
The benefits of the power of compounding are immense – you can quickly maximize your savings and investments to support your long-term life goals financially. All you have to do is make an early
start and be patient with your investments so that you do not hinder their growth potential. Instead, you must remain invested for an extended period to fully leverage the power of compounding. You can reap compounding benefits from a variety of investment options in India including fixed-income and market-linked instruments.
At the same time, you can avail of significant tax benefits with investment under 80C. This way, you can easily augment your savings with a reduced tax liability – making sure that that you stay on track towards a life’s worth of disciplined long-term returns, courtesy the power of compounding.
Overall, you can maximize the effect of power of compounding on your investments while keeping risk at bay and time horizon in mind.
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