Power of Compounding – How It Works?

Visualizing Extraordinary Power of Compounding

Introduction

In the earlier article – Cost of Delay In Investing, we have seen that how a few years delay in investing affects the final corpus. In this article, we are going to discuss about the eighth wonder of the world ie. Power of Compounding. Investing early is as important as investing wisely. It is all because of the Power of Compunding. Compounding earnings can multiply and thus expand small investments also.

What Is Power of Compounding?

• 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.
• It simply means – ‘interest on interest & principal’ which is what separates it with Simple Interest where you get interest only on principal.
• Thus, it creates a chain reaction by generating returns on the returns as long as your money remains invested in the financial instrument. The arithmetic of compounding means that investments start generating disproportionately higher amounts after some years.

• While most investors focus only on “R” (How much Returns?), they completely underestimate the power of “P” (an average retail investor invests only 3-4% of her wealth in stocks and equity mutual funds) and “n”, which is nothing but time in the market.
• It is this combination of all the three elements, higher investments coupled with reasonably higher returns over a longer time frame — that will create astounding wealth.

Example :

If you invest Rs. 10,000 at 5% interest for 20 years, you’d earn Rs. 26,532.98 i.e. Rs. 16,532.98 in profit (ignoring taxes and fees). But if you doubled the rate of interest to 10%, how much would you earn? It might seem that doubling the rate would double the return, but that’s not the case. Doubling the rate of interest, increases the return by nearly 253.55%. Instead of earning Rs. 26,532.98; you would earn Rs. 67,274.99 i.e. Rs. 57,274.99 in profit.

That’s the power of compound interest. Money doesn’t grow linearly like in simple interest — it grows exponentially.

Simple Interest vs Compounding Interest

Below given is a comparative analysis which can help you understand, how compounding works in different scenarios and how it is compared with the simple interest.

How to Get the True Benefit of Compounding?

Basically, Compounding is a long-term investment strategy. Compounding is a simple but powerful concept of investing acts as a multiplier in your investment portfolio. The great thing about compounding is that you will eventually reach a point where the amount of money reinvested will become greater than the original principal amount.

1. Start Investing Early : All you need to do is start investing early and over time, compounding will grow your money for you. The earlier you start investing, the greater will be the power of compounding.
2. Invest in a Regular and Disciplined Manner : In order to create a healthy portfolio, it is very important that you define your financial goals and be regular in your investments. Reagrdless of how less you earn, a disciplined investing habbit would help you build a descent corpus.
3. Have Patience : 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.