Magic of compounding: Does it actually work? Let's find out!

Wow! Yet another article on the magic of compounding. You probably know the drill. Start saving and investing early, keep investing for a few decades and remain invested to see the magic of compounding. Yes! It’s that simple. Compounding as a concept is something that all of us learnt in school. However, what the schools forgot to teach is the back ended nature of compounding.

Compounding is a force that can either work for you or against you. The general financial definition of compounding is that interest earns more interest that leads to growth of capital. It is up to you to decide how you want it to work for you. Compounding works for you as an investor and as a borrower.

When you use compounding to your advantage (as an investor), your wealth grows but when you use compounding as a borrower it works against you, it generally leads to reduction in your net worth. Negative compounding primarily works when you borrow money for discretionary expenses to buy things you do not need in the first place. For example, many times, people buy expensive mobiles, watches, holidays – just because these are available at no cost EMI.

The compounding works in everything – investing, fitness, habits, everything.

Three essential ingredients of positive compounding

Let us focus on positive compounding. There are three essential ingredients that you must focus on when you are planning to use compounding in your favour.

The first and most important ingredient is principal. The more capital you save and invest, the higher will be the impact on your net-worth in the later years. In the early years of your life, try to maximise the capital that you can invest.

The second and most powerful ingredient is time. We all want to get rich quickly. While it is possible, the chances are low. However, by increasing the time horizon, you can make compounding work for you.

The third ingredient is returned. One should focus on generating returns higher than inflation after paying taxes. Avoid risk of complete ruin for example – future and option trading, gambling, unregulated instruments. One should never be obsessed with maximising the returns and should focus on decent returns for long periods of time. By the way, this is the only ingredient, which is uncertain.

Does the magic of compounding actually work?

It works. The money compounds in a savings bank account as well. However, the goal always must be to grow the capital at a return over and above inflation. The best example to explain the magic of compounding is the public provident fund and employees’ provident fund.

If you contribute ₹1.5 lakhs in Public Provident Fund, every year, at the beginning of each year for the first 15 years and let the money sit there for the next 15 years, the balance at the end of 30 years would be approximately ₹1.13 crores (@7.1%). Can you guess the total invested capital? It’s just ₹22.5 lakhs.

In the above example, you earned ₹90 lakhs in interest only provided you waited for another 15 years after the first 15 years of consistent investments. But one must understand the back end nature of compounding as well. The returns in the last 4 out of 30 years were ₹27.31 Lakhs (greater than the first 15 years of capital contribution).

The challenge with an investment instrument like PPF is that it generally grows at a rate of returns which is close to inflation. When the time horizon is more than a decade, you must focus on optimising returns by investing in instruments that earn a little higher than inflation. For example, you can consider equity mutual funds.

Nishant Batra CWM® is Chief Goal Planner of Holistic Prime Wealth.

Disclaimer: The views expressed in this article are of the author, not MintGenie.