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Power of Compounding

“Compound Interest is the eighth wonder of the world. He who understands it earns it. He who doesn’t pays it” – Albert Einstein

Wealth is not generated as a windfall income on speculation basis. Wealth creation is an art, and it can only be attained by skilful handling of one’s resources. Wealth creation and its management are products of discipline that initiates quality wealth management. No matter how small an amount you set aside, it all gets accumulated in the ocean you want to see. We generally neglect the strength of compounding as the catalyst of gathering a large fund.

Benefits of Compounding Interest in Long Term Investment

Let’s understand the power of compounding under long term conditions. For instance, Rakesh, a software engineer, made an investment of INR 5000 @ 8% interest at the age of 20. Rakesh wants retirement by 50 years of age and therefore, he was saving for this retirement fund. A simple calculation will show the vast difference of his fund performance under simple and compound interest.

Though annual investment remains same, the compounded return increases proportionately. The returns are accelerated now, though Rakesh invested only INR 5000 annually. The previous interests he had will be re-invested annually to bring profits. Longer the investment window, higher the growth of profits.

While every year is precious in the world of compound interest, at times, we defer our investments to meet our urgent expenses believing that we may start investing next year. The earlier you start, the better it is.

How Does Compounding Work

Compound interest functions by gaining interest on money that was previously earned as interest. A cycle that leads to increasing interest and balance at a rising rate or what is called exponential growth.

Function:

  1. You deposit money, and the
  2. bank pays you interest on your deposit.
  3. Assuming you deposit INR100 for one year at 5 percent.
  4. You earn INR5 as interest over the year. What happens next year?

This is where compounding comes in. You will be earning interest on your first deposit and you’ll earn interest on the interest you earned on the first deposit. This is how compounding works. It happens when your first investment earns a return, and this return in turn earns a return and so on over a period of time.

Let’s observe compounding work in the investment scenario.

  1. You invested INR10,000 in a deposit which pays an interest rate of 10 per cent annually.
  2. In the first year, the interest earned is INR1,000. You now have INR11,000 (INR 10,000 + INR 1,000). This total amount will earn interest in the second year.
  3. That results in an interest of INR1,100.

What is happening is that the INR1,000 that you earned in the first year is in turn earning INR100 in the second year. So, at the end of the second year, you have INR 12,100 in your hand. After 10 years, the INR10,000 would have grown to INR25,937.

Let’s see how compounding functions with instruments like a mutual fund.

  1. You invest INR 1 lakh in two mutual funds with NAVs of INR 10 and INR 250 respectively.
  2. A year later, both the funds’ NAVs rose by 10 per cent to INR 11 and INR 250.
  3. Your investment is now worth INR 1.1 lakh.
  4. At the end of the second year, both funds again saw their NAV rise by 10 per cent.
  5. Their NAVs now become INR 12.1 and INR 302.5. The value of your investment has compounded to INR1.21 lakh.

How to Make the best use of compounding

Start early for a really long investment window

When people initiate early investments, they are able to see the investments grow and make her/his post retirement life quite smooth. An early investment can start with the start of regular income for a person. Set aside a percentage of your earning and invest it with discipline.

Go for high return investment instruments

If you invest in a bank’s fixed deposit earning an interest rate of 7%, after 20 years Rs 1 lakh would grow to Rs 3.87 lakh. This accounts to almost half the corpus of the investment earning 10% per annum. Instead, if you could to invest in a product that earned 14% p.a., the Rs 1 lakh investment would now be would worth a whopping Rs 13.74 lakh.

Clearly, a small difference in interest rate can make a huger difference in returns over the long term.

Regular Investment

Well, it’s common sense that if you invest a higher amount, you will have a bigger corpus at the end of the investment horizon. This is, however, an aspect of investing that is often not taken seriously. Many invest in an ad hoc manner. In spite of income and savings increasing every year, their investment amount remains stagnant. But, regularly increasing your investment amount can make a huge difference over the long term.

Besides, regular investment goes a long way towards taking advantage of the equity market volatility. You will be able to average out your costs by buying more units when the market corrects.

With SIPs, you imbibe a regular investment habit that can compound your wealth and enable it to grow by leaps and bounds. If you had invested Rs 2.4 lakh two years ago, the total value of portfolio would be Rs 3,38,667. However, if invested Rs 10,000 every month, the total value of his portfolio value would be Rs 3,41,285.

Patience

This makes for one of the most important ingredient of wealth creation. Panic spoils it. Power of compounding is perceived only when investments go for growth at their own. Initially it will look like investments are static, yet in some years of disciplined investment, you will be surprised to assess the effect of compounding to your portfolio.

Better Spending Habit

In the world of material humans, financial needs can be endless. Therefore, it is smarter to initiate savings and make it a habit.

FAQs on Power of Compounding

What is the power of compounding?

With compound interest, the first year’s interest is added to the principal. For the second year, therefore, the principal which is now earning interest is higher. The principal will become larger in the coming year, and even bigger in the year after that, etc. This means that every successive year’s interest will be correspondingly greater than in past years. Therefore, if you invested Rs. 1 lakh today in an investment growing 10% annually compounded, after 20 years, the investment would be worth as much as Rs. 6.73 lakh.

What does compounding money mean?

Compounding is an operation in which the earnings from an asset, such as capital gains - interest, see re-investment to develop more earnings over period of time. This growth is often summed using exponential functions and it incurs earnings from investments from its initial principal and the accumulated earnings from previous periods. This means compounding is not same as linear growth, with only the principal earning interest.

How interest is compounded in SIP?

Let's see how the concept of compounding works. Assuming Saurabh started investing INR 2,000 per year at the age of 19. Upon reaching 27 years of age, he ceases investment and locks all his investments till retirement. Rahul on the other hand, does not invest until 27 years of age. At 27, he starts investing INR 2,000 a year till the age of 58. You will see that Saurabh makes more returns on the whole.

Why is compounding important?

On occasions of a shortage of drugs, the compounding pharmacists are able to compound drugs that are short in supply. This is applicable on drugs that have been discontinued and are no longer available commercially. In hospitals, most often the lifesaving intravenous solutions are compounded.

Do mutual funds pay interest?

A fixed deposit in a bank pays you interest, even as an investment in a mutual fund offers you a dividend. This is a misconception, however, as MFs not being securities themselves cannot pay interest.

What does compounding pharmacy mean?

In place of normal packaging of antibiotic and fungal medicines, the compounding pharmacy chooses on-site package and mixing of medical prescriptions.

What do you mean by compounding?

In the process of compounding, there is exponential increment in the value of an investment since it earns interest on both principal and accumulated interest.

What does compounding interest mean?

Compounding interest is calculation made up on the principal amount and on the interest gathered from previous deposit periods. Compounding interest is interest paid on interest that makes principal sums grow at a faster rate than simple interest, which is calculated only on the principal amount.

What does compound interest mean in Math?

Compound interest is summed from the principal and on the interest gathered from previous time windows. This makes it an interest on interest. Note that a big difference will show up in the amount of interest payable on a loan when interest is calculated compound instead of a simple basis.

What is compounding in linguistics?

In the realm of linguistics, a compound is a multi-stem element. Compounding, composition or nominal composition is the word formation process that gives birth to compound lexemes.

What does compound effect mean?

This could be understood as the additional growth from the compounding effects of interest on interest. For instance, interest at 6% per annum, compounded every year, for 2 years maturity will deliver gathered interest in two years = [1. 06 x 1. 06] - 1= 12. 36% for the two-year time window. Removing all additional interest from interest, the total is a simple 6% annual x 2 years. This is 12. 00%.

How do you calculate interest compounded daily?

Financial institutions vary in terms of their compounding rates - daily, monthly, yearly, etc. As a simple example, a savings account with Rs. 1000 principal and 10% interest per year (compounded yearly) would have a balance of Rs. 1100 at the end of the first year.

What is power of compounding?

With patience, your money can compound itself making a difference in your overall balance, which inturn makes your earnings give birth to further earnings. This means that the interest received is not only on the original investment, but also inclusive of any interest, dividends, and capital accumulation. So, your money will grow faster as the years fly by.

What is the formula of compound interest with example?

Yearly compound interest, inclusive of principal amount: A = P (1 + r/n) (nt) Assuming:

A = the future value of the investment/loan, including interest P = the principal amount invested. r = the annual interest rate. n = Annual interest compounding. t = Money invested or borrowed for this time period.

Example:

If an amount of INR 2.5 lakh is put into a savings account with an interest rate of 5% annually, compounded monthly, the value of the investment after 10 years can be calculated as follows:

P = 2.5 lakh. r = 5/100 = 0.05 (decimal). n = 12. t = 10. When we put those figures in formula: A = 2.5 lakh (1 + 0.05 / 12) ^ (12(10)) = INR40,11,000 So, the investment balance after 10 years is INR40,11,000

How do you calculate interest compounded continuously?

In earlier days when people had a bank account, every year their balance would increase along a factor of (1 + r/4)4. Now it has become possible to compound interest on a monthly and daily basis. This means that the balance rising by a small factor up on each instance.

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