What if you could earn interest money on your savings and then again earn interest on the interest earned? What seems like a miracle is indeed the “Magic of Compounding” that ignited interest in the most fertile minds like that of the famous physicist Albert Einstein. Einstein had described compound interest as the “eighth wonder of the world” saying, “He who understands it, earns it; he who doesn’t, pays for it.” Compounding is the basis for all wealth creation, which is why you must invest correctly and for a long period.
How does the compounding magic compound your earnings?
As opposed to the misconception about the compounding method being a tedious affair, the compounding process is too simple. It involves simple calculations that can help multiply your potential earnings from the money that you have invested.
You must first invest money to benefit from the compounding process. This process then ensures that you earn interest on your original investments and then re-invest the interest to earn more interest on the returns. This can be explained by the following example.
Suppose you have invested ₹5000 at 10 per cent annual interest. Let us now see how the compounding process helps you to grow your money in the coming Year 1, Year 2 and Year 3.
|Year||Calculating the interest earned||Interest amount earned||Amount at the end of the year|
|Year 1||5000 * 10%||500||5500|
|Year 2||(5000 * 10%) + (500 * 10%)||500 +50 = 550||6050|
|Year 3||(5000 * 10%) + (1050 * 10%)||500 + 105 = 605||6655|
The compounding process is continued in nature. However, knowing about this process is futile unless
You start early
You cannot time your investments, but you surely start them early to ensure that your investments get more time to grow. Ideally, you must start investing as soon as you start earning. You must utilize your first paycheque to invest your earnings in your choice of investment depending on your financial goals and risk profile. This is because the compounding process shows the best results if you start early and stay invested for a prolonged period. This means that even if you invest more later in life, the compounding process will not have the desired effect despite you putting in three times the investment later. The cost of delay is what causes many investors to lose out on returns on their investments.
Persistence is the key
You must stay invested, which means that you must be disciplined about your investments. The compounding process will have the desired effect if you stay invested from the day you start investing. A small gap or an unwanted delay in investments can take a toll on your earnings and consequently affect the growth of your wealth too.
Be prepared to wait
You must not dream of creating wealth overnight. Remember that Rome was not built in a day though it took a mere few hours for Hiroshima and Nagasaki to be doomed. History teaches us the importance of being patient with our investments. Wealth creation takes time, which is why we must wait for months and years till we see the corpus gaining strength from time to time and swell into an amount in sync with our financial goals. Remember that Warren Buffet earned 99.7 per cent of his wealth after his 52nd birthday. Stay invested in businesses for a long period if you want to enjoy “The Compound Effect”.
Compounding your money through mutual funds
It is impossible to remember to invest every month. So, why not automate the investment process? This is possible only when you invest your money through systematic investment plans (SIPs). Mutual funds allow their investors to park their money through both lump sum and SIP investment options, thus, letting you avail of the dual benefits of investing regularly and at once when you have surplus money left to invest. This way you not only gain from the compounding process but also automate the same to further your investments.
When you invest via SIPs, you park your money into a mutual fund scheme of your choice at regular intervals. This ensures discipline and persistence to continue with your investments. Moreover, investing through SIPs means that you can start investing money with an amount as low as ₹500. The SIPs amount can go up with time as you earn more salaries or earn appraisals and bonuses.