When we say “power” of compounding, we’re not making any overstatement. The compounding effect on a regular investment of a small sum of money over a long period of time, can accrue a huge corpus of money.
Many investors tend to ignore the fact that the compounding effect on their investment is the prominent accelerator for growing one’s wealth and building a great corpus.
What is the Power of Compounding?
Power of compounding essentially refers to the interest you earn on your accrued interest. So, if you invest a certain principal sum of money in a financial instrument, and earn interest on the same, through the compounding effect, you will also earn interest on your interest in the late years of investment.
Let’s understand this with an example. For instance, if a person has invested Rs. 1 lakh in an investment instrument. This is how it will grow over the period of 5 years at different expected interest rates.
|Year||Investment Amount (₹)||Expected Rate of Interest|
Here, there’s a massive gain for each rate of interest, much larger than the investment would have gained at simple interest, i.e, interest earned on just your principal investment. The principal amount has gained ₹76,000, at 12% compound interest rate, as opposed to a gain of ₹60,000, when invested at 12% simple interest.
Benefits of Compounding in a Long Term Investment
To know how the power of compounding does wonders in a long term investment horizon, we will take up two scenarios: one-time investment and systematic investment over a period of 30 years.
Mr. A, an IT engineer invested Rs.5000 @ 12% at the age of 30. He wanted to retire by the age of 60 and was saving for his retirement corpus. Take a look at how his investment will perform under simple and compound interests.
|Under Simple Interest (12%)||Under Compound Interest (12%)|
Here, we can well understand if just one time investment can become this, then what wonders can happen if systematically a little is set aside every month or even every year.
Now let’s see how a yearly investment of ₹5,000 will grow over a span of 30%, taking 12% as the expected annual rate of return. To arrive at the final value of investment for this specific calculation, we need to use a compound interest calculator or, as it is very tedious to use a formula for this.
Post calculating the above value through the calculator, we arrive at the final value of ₹13.46 lakh. A total investment of ₹1.55 lakh grows to ₹13.46 lakh over a tenure of 30 years. So now it is clear what the magic of compounding can do to our money. If we start investing early, money would start earning for itself.
How Does Power of Compounding impact Mutual Funds?
Mutual Funds have become a popular investment instrument in recent times, owing to the myriad of advantages that they offer. One of the benefits is the power of compounding, which is an intrinsic part of how mutual funds work, and generate exponential returns over a long run.
The whole concept of Systematic Investment Plan (SIP) is to take advantage of the compounding effect, while you invest a small sum of money at predefined intervals. The invested amount grows exponentially over a long span of time. For instance, if you start a monthly SIP of ₹5,000, to build your retirement corpus, and invest for a period of 30 years at an expected rate of return of 15%. Your money would grow exponentially, as you reinvest your returns. To arrive at the final value of investment, we use SIP Calculator.
Post calculating the above value through the SIP calculator, we arrive at the final value of ₹3.46 crore. A total investment of ₹18 lakh, over a tenure of 30 years, grows to a whopping amount of ₹1.74 crore, only because of one thing, “the power of compounding”.
The Thumb Rules of Investing
- Start Early:
The key rule of making it big is to start investing as early as possible. The recommended time to begin your investment journey is the day you receive your first pay cheque. If you have not started investing yet, start now. Postponing savings can make it difficult for you to reach your destination.
- Be Regular:
Regular investments make your portfolio healthy. Disciplined and dedicated contributions work best to create wealth. Define priorities. I have heard many people saying that with this little income I am not being able to meet my needs, how can I think of investing some. For them I only have one suggestion, think that you are getting 10% less salary. This means if you are earning say Rs. 10000 a month, think that your salary or income is Rs.9000. Invest this Rs.1000 and you shall thank me later in life.
- Patience is the Key:
This is the most important ingredient of wealth creation. Do not take haste investment decisions in a moment of panic. Power of compounding is felt and seen only if investments are allowed to grow at its own pace. It may seem that investments are not growing, but after years of dedicated and disciplined investment you may be surprised to see what compounding does to your portfolio.
FAQs on Power of Compounding
Q.1: What is the power of compounding?
Ans: Power of compounding is a money multiplier strategy used in Mutual Funds. Under this, the interest earned on principal is reinvested so as to earn interest on interest or profit on profits. This strategy allows the interest earned to also earn interest leading to a growth in the value of investment.
Q.2: How do you take advantage of compounding?
Ans: One of the biggest advantages of compounding is that you can appreciate the value of investments. As it reinvests your interest or profit earned on principal investment, helping you earn on the interest income as well, a chain reaction or multiplication of investment occurs till the time you keep your funds invested. You can take advantage of compounding by-
- Starting investments as early as possible in order to create a solid foundation of wealth.
- Ensure regularity/discipline in your investments as disciplined contributions work best to create wealth.
- Be very patient and keep your final goal in mind. Power of compounding is felt and seen only if investments are allowed to grow at its own pace.
Q.3: What does compounding interest mean?
Ans: Compounding Interest, in simple terms, refers to the interest which is accrued on the initial deposit including all of the accumulated interest. You can also understand it as ‘interest on interest’.
Q.4: Is it better to compound interest daily or monthly?
Ans: Monthly Compounding of interest means that your interest on investments is calculated and then added to your account at the end of every month. Whereas, in daily compounding the interest is calculated and added to the account at the end of every day. The basic principle of compounding suggests that the shorter the compounding term, the more interest you earn. Hence, it is better to compound interest daily than monthly.
Q.5: What is 15*15*15 rule of Mutual Funds?
Ans: The 15*15*15 rule of Mutual Funds is a concept of accumulating Rs.1 crore by investing Rs.15,000 per month. The key tool behind this calculation is compounding interest. Let us understand it a little better-
- For instance, Mr.A decides to invest Rs.15000 per month via SIP in equity fund for 15 years and generating 15% returns
- Total investment: Rs.15000*180 months=Rs.27 Lakhs
- Profit generated (Interest income): Rs.73,00,000
- Total accumulated money: Rs.10,000,000
- Now, if he increase the investment period by another 15 years, his wealth would increase 10 times
- So, Investment amount in 30 years: Rs.15000*360months=Rs.54 Lakhs
- Total accumulated money: Rs.10.38 crores
- Profit becomes: Rs.9.84 crores
Q.6: How does compound interest work in investments?
Ans: Power of Compounding is used to the fullest in mutual funds when an investor invests his/her money for a longer period of time. Investors enjoy gains when the value of fund units increase. In mutual funds, it is carried out when the capital gains are reinvested to create additional profits. Here is an example of power of compounding in mutual funds:
- Mr.A has decided to make lump sum investments worth Rs.1,00,000 a year for 10 years at 12% interest
Power of compounding:
|Year||Principal Amount (Rs.)||12% Interest (Rs.)||Closing Balance (Rs.)|
Total Interest Earned: Rs.2,09,931.52
Total value of investment after 10 years: Rs.3,09,930.72