The wonders of Science did not stop the famous scientist Albert Einstein from referring to compound interest as the eighth wonder of the world. Unanimously declared as the most potent force in the Universe, the rule of compounding is the most cited concept by investment experts.
Compounding means that you not only get the interest on the principal amount invested but also on the interest earned. This is equivalent to folding a paper twice or thrice or more times on itself till it becomes thick and looks stocky. A piece of paper folded 103 times on itself becomes as thick as the universe.
Unfolding the magic of compounding
Then think of how your money if invested regularly over a prolonged period helps you earn more money. The magic of compounding underscores the saying “Wealth begets wealth”.
Let us understand how the compounding process works with the help of an example.
Assume that you invest ₹5000 annually at a 10 per cent interest rate.
| Year | Amount Invested | Calculating the Interest Earned | Interest Earned | Amount earned on year-end |
| Year 1 | 5000 | 5000*10/100 | 500 | 5500 |
| Year 2 | 5000 | (5000*10/100) + (500*10/100) | 500+50 | 6050 |
| Year 3 | 5000 | (5000*10/100) + (1050*10/100) | 500+105 | 6655 |
The aforementioned table elucidates how you can earn an interest of ₹500. However, in the second year, you earn interest on the amount beyond your investment. You also earn interest on the interest earned during the previous year. The total interest earned during the second year will then amount to ₹550. In the third year, you earn interest on the amount invested plus the interest on the interest earned so far, thus, taking the total earned amount to ₹6655.
The process of compounding is continuous and shows effect only when the amount is invested for a prolonged period.
Making the most from compounding
You may rely on the magic of compounding if you are looking to compound your wealth. However, for the compounding process to lend and show its palpable effect, it is necessary that
- You start investing early: You must start investing as soon as you get your first salary. However, this does mean that you have missed the bus entirely on starting your investment journey late in life. The compounding effect has a maximizing effect if invested later though you can make up for the loss by investing regularly in high-interest rate instruments. Opportunity loss due to delay can have a huge impact on your returns.
- Disciplined investments: You can benefit from the power of compounding and attain your financial goals only if you stay invested continuously for a prolonged period. You have to inculcate a disciplined investment habit throughout your investment journey. A sudden pause or gap in investments can cause you to lose out on a lot of money in the end.
- Patience helps: It takes brick by brick to build a wall. Patience is the key to building wealth. You must understand that wealth is not created overnight. You must devote enough time to create a corpus that will help you to achieve your financial goals. At times, market movement may deter you from making further investments. Withholding investments out of fear will impede your goal to retire rich.
Our busy lifestyles do not always allow us to take note of our investments. This explains why you must automate your investments. Investing in mutual funds through systematic investment plans is the best to continue your investments without having to worry about paying regularly for a long period.