What is power of compounding?
Compounding takes place when the interest generated on the principal in the first period is added back to the principal in order to calculate the interest for the following periods. Usually, the word “interest" is used to refer to the returns generated by a fixed-income instrument like a Fixed Deposit (FDs). But the workings of compounding is not limited to FDs. It includes all other investment where the returns earned in the previous year is reinvested in the following years. The biggest advantage of compounding is that it takes the time value of money into account. Which means that by investing in instruments like equity and equity-related mutual funds, you can generate an amount good enough to beat the inflation rate.
Thus, generating returns on the returns becomes a chain reaction as long as your money remains invested in the financial instrument. Mathematically, you may understand the concept of compounding as a scenario where your returns grow at an increasing rate and you receive disproportionately greater amounts with each passing year. However, do not confuse compounding with get-rich-quick schemes. Compounding is altogether a different concept from those other ponzi schemes where the perpetrator promises to double your money in an unreasonably short span of time. But in case of compounding you need to be a long-term investor to create wealth.
How compounding helps in wealth accumulation?
Compounding means that the initial returns that you earned on an investment becomes part of the invested capital. Over a particular investment horizon, compounding helps to create enormous value addition to the original capital. Because of this quality, compounding has been regarded as the eighth wonder of the world. Those investors who are aware of this mechanism are able to make better investment decisions. They spot these opportunities accordingly and fetch higher returns on investment as compared to those who lack knowledge about the power of compounding.
Let us understand the magic of compounding with the help of an example. Suppose there are two investors A and B who are looking for opportunities to create wealth. They spot an opportunity where interest can be earned at the rate of 10%. Both of them decide to stay invested for a period of 5 years. Investor A opts for interest being calculated as compound interest while B opts for interest being calculated as simple interest. At the end of 5 years, investor A accumulates a corpus which is Rs 11051 higher than investor B’s corpus.
|Particulars||Investor A||Investor B|
|Rate of Interest||10%||10%|
|Duration of Investment (in years)||5||5|
|Amount at maturity (in Rs)||161,051||150,000|
|Difference in final value (in Rs)||11,051|
Because of compound interest, in case of A, the interest that A earned in the previous period was included in interest computation for the next period. In case of B, for every period, interest was calculated on the initial principal only. Because of the power of compounding, investor A became richer than investor B.
Compounding has immense use mostly in the domain of finance and investment. In case of bank fixed deposits, when you let the interest accumulate throughout the duration instead of withdrawing it every month,you get a higher amount in the end. Mutual funds have been successful in making use of this concept in the most effective manner. They do so by means of giving “growth” option. In this, all the profits earned by the scheme are reinvested in the scheme by the fund manager. It, thus, allows a higher amount to get invested in the underlying scheme which generates a higher return than the “dividend” option of the mutual fund scheme.
Archit Gupta is Founder & CEO, Cleartax