Understanding the power of compounding and factors that affect it

Pranati Deva
Updated: 14 Dec 2021, 05:14 PM IST
TL;DR.

The power of compounding helps investors gain massive wealth over a longer period of time. Let’s take a look at how it is calculated and how you can use it to your advantage.

The power of compounding helps investors gain massive wealth over a longer period of time.

The power of compounding helps investors gain massive wealth over a longer period of time.

American businessman Jim Rogers once said 'Compounding is the magic of investing.’

Compounding is basically the increase in your investment on the interest earned as well as accumulated interest. This tool, which is mostly used in mutual funds and stocks, helps grow your wealth exponentially. If planned well, it could be very useful for future goals or even in generating a massive corpus for retirement.

Compounded interest means the interest on interest. Every time you earn interest on your principal, it gets added to your original principal amount. So the next time you earn the interest on the increased principal amount. Over time, this allows your interest to grow drastically.

Meanwhile, simple interest is just the interest amount earned on your principal. There is no accumulated interest to factor in.

For example, suppose you invest 5,000 in a mutual fund. This amount earns you a return of 500. Then this return is added to the original investment amount, making the principal 5500. Now, you will earn interest on 5500 and not 5000 which will keep on increasing till you redeem your investment.

However, in simple interest, if you invest the same amount 5,000 and get a return of 500. The principal amount will remain the same, only the interest will get increased over the years.

However, one must note that you have to give a considerable amount of time for the power of compounding to work. If you withdraw your interest, say just after a year or anytime in between, it will not be able to earn as much. Premature withdrawal will lead to limiting the growth potential of your investment.

Let's take a look at some factors that affect the compound interest

Interest rate: Higher the interest rate, the better will be the corpus accumulated.

Time: The more the time duration, the more interest you can generate.

Frequency: If the interest is calculated more frequently, the total returns will be more. If interest is accrued quarterly or semi-annually, the total returns would be more than if it is accrued annually.

Annual: Interest is calculated once a year

Half-yearly: Interest is calculated every six months

Quarterly: Interest is calculated once every three months

Daily: Interest is calculated every day

Where all you can invest

Mutual funds and direct stock trading uses the power of compounding to generate maximum returns. In mutual funds, you can buy units with a lump sum amount as well as in SIP mode.

In the lumpsum mode, the principal amount, say you invest 1,00,00 will only increase as per the interest earned on it. Suppose the interest is 12 percent per annum, then in the second year, your principal amount will increase to 1,12,000, and in the third year 1,25,440 (with the same interest rate). Note we are taking the same interest rate for each year for easier calculations, however, in equity funds, the rate of interest earned every year differs depending on the market performance.

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Understanding the power of compounding

However, in the case of a SIP. Your principal amount not only increased with the interest earned but also with the regular payments you make. So suppose you invest 5,000 per month, you would have invested 60,000 per year. So suppose you earn an interest of 7,200 in the first year, the second year your principal amount will not be 67,200 but 67,200 + 60,000 (your investment for that year), making the total principal be 1,27,200. Since your principal amount is also increasing massively, the total wealth creation will be more in this case.

 

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Power of compounding

Apart from equity trading and mutual funds, you can also invest in government schemes like FD, RD, NPS, if you do not want to be vulnerable to volatilities in the market.

Inflation and compounding

Inflation erodes the value of money over time. It is the opposite of compounding. Suppose you invest 1 lakh which earns you an interest of 8 percent a year. But at the same time, the inflation is around 6 percent for the year. Then your compounding returns will just be a little more than the inflation.

Even though you will get your money, the value of money will decrease and you will be able to buy lesser items in the compounded money as you could have bought earlier.

Let's look at an example. Suppose you invest 1 lakh for 10 years at a 12 percent per annum interest rate. This would get you 2.77 lakh after 10 years. However, the rate of inflation for those years has also been around 8 percent per year. Then the items you could have bought for 1 lakh will cost over 2 lakh after 10 years, hence your overall gain will only be around 50,000-60,000 after 10 years if we count the inflation.

So while the power of compounding helps investors gain massive wealth over a longer period of time, it is important to include inflation in the account. However, you can start investing early and accumulate for a longer period to fulfill a financial goal.

First Published: 14 Dec 2021, 05:14 PM IST
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