Do you know which is the most powerful tool that works continuously on itself to yield great results? It is the compounding tool that works on a magic unmatched. Albert Einstein while describing the magic of compounding described it as the eighth wonder of the world. Nothing matched its power that helps to grow savings exponentially.
The magic of compounding is best explained in the investing world as a tool to explain how money grows when parked continuously for a prolonged period. You have to stay invested for a decade or so to realize the compounding effect on your money. This is because the compounding process is more than just earning interest on your earnings. It entails interest earned on the interest earlier earned, which means that you earn more interest than before.
Let us understand the benefit of compounding using the simple example of the DSP Nifty 50 Equal Weight Index Fund which has earned 12.36 per cent average returns since inception.
| Year-end | Amount invested every year (in Rs) | Calculating interest earned every year (in Rs) | Interest earned (in Rs) | Amount at the end of each year (in Rs) |
| Year 1 | 5000 | 5000 * 12.36% | 618 | 5,618 |
| Year 2 | 5000 | (5000 * 12.36%) + (618 * 12.36%) | 694.38 | 6312.38 |
| Year 3 | 5000 | (5000 * 12.36%) + (1312.38 * 12.36%) | 780.21 | 12,710.59 |
The compounding process is repetitive and, hence, investors benefit only when they park their money with a long-term perspective. This is because they earn manifold returns only when they invest their earnings over a long period.
How does compounding help?
Compounding is a great way to earn wealth. Those who are looking to build a lump sum corpus over a decade or more make the most of this compounding process. However, the compounding process has a lot to do with the investment tenure, which means that you must invest early to earn maximum returns. Investing early in life, for example, after receiving your first paycheque, will help you earn more returns than later investments. Apart, when you invest your money for around 30 years, the interest earned will be a lot more than when kept for 15 years alone.
Delayed investments will not yield much even if the amount is parked at higher interest rates. Many investors misconstrue that an increase in the amount of investment at later stages will help make up for the lost returns.
