- What is Compounding?
- How does it work?
- Advantages of Power of Compounding?
- Key rules to enable the Power of Compounding?
What is Compounding?
First let us understand what Compounding means, and what is the Power of Compounding in simple words Compounding means the gains of an Asset from interest or capital gains, this income grows overtime when the interest and the gain of the Asset increase over time,
For many of the people, the power of compounding looks like a difficult topic. But it is not so. I will help you to understand this in the simplest way.
Let us assume that you invested Rs.50,000/- at the rate of 8% p.a. The interest for the year would be Rs.4000/-. So, when the interest is not used by you and reinvested in the same investment, the earning for the coming year would become an investment of Rs.50,000/- + Rs.4000/-. This means, the earning for the second year would be Rs.54,000/- at the rate of 8% p.a. that is Rs.4320/- As the years pass, the interest for the year keeps on increasing because there is an additional investment of interest each year.
It is believed that according to the great scientist Albert Einstein, the great force in the universe is the principle of compounding. This force exhibits itself through the theory of compounding interest.
In simple words, compound interest means to earn interest on the interest you earn, which multiplies your money at an accelerating rate?
This is the magic for the success of many top investors like Warren Buffet. Anyone can take advantage of the benefits by investing in a disciplined manner.
The Three Elements That Determine Your Compound Interest Returns are
- The Interest Rate on your investment, if you are investing in the stock market, this will be your total earnings from capital gains and dividends.
- Time is the key factor in compounding. The more time you give the more will your money will build upon itself and the more it compounds.
- Tax is another element, if you pay your taxes at the end of the compounding period you would end up saving more.
How Does it work?
Mathematically speaking, the definition of compounding, ‘the increase in the value of an investment, due to the interest earned on the principal, as well as the accumulated interest.’
Simply assume it as a magic that makes your money work for you. It could be noted as a powerful tool to grow your wealth. You can utilize the power of compounding in planning your future goals, such as retirement.
Difference of Simple and Compounding interest is in Simple interest you earn interest on your principal amount. But with compounding interest, you earn interest on the principal amount as well as the accumulated interest amount over the period. Over time, this interest becomes great than your principal amount.
Here’s an example of the power of compounding.
Mohan and Pramod both invest Rs 10,000 each in a financial instrument that gives an annual interest rate of 12% for 20 years. Where Mohan opts for simple interest, Pramod opts for compound interest
At the end of 20 years, Mohan would make a total of Rs. 2,64,000/- whereas on the other hand, Pramod would have made a corpus of Rs.8,07,000/- This is because in Mohan’s case, the interest was calculated only on the initial principal amount of Rs.10,000. But in Pramod’s case, the interest earned for each year was added along with the principal amount to calculate the interest for the next year. This helped increase Pramod’s earnings in a great way.
Advantages of Power of Compounding
One of the main benefits that investors can get from the power of compounding is the value of time. With increasing time, you will gain returns, and the returns on these returns could further generate returns; thus, helping to increase your investments quickly.
Saving money and earning compound interest amount every year is an art and a good thing. But what if you have to invest a fixed amount each month? This small investment would boost your returns over time. Let’s see how is that possible?
Imagine you invest Rs. 10,000 every month. The interest on this amount is 8% per annum. The table below makes you understand how your investment returns would look like over time:
The above table explains the concept of the power of compounding
This example makes you understand the compounding principle where the wealth gain rises exponentially over five years. And at the end of 30 years, the investment capital of Rs.36,00,000/- have grown multiple times to a corpus of Rs.1,50,00,000/-
There are many takeaways from the above table that we can understand, they are:-
- It is important to begin saving and investing from an early age. And when you make it a regular habit for a particular period, you would have an opportunity to maximize your returns and gains by the full power of compounding.
- Most of the people assume it in the wrong way that they can start investing only when they have large funds. Therefore, they delay investing until they get into their mid-forties. This is not the right strategy to invest. But if you start investing from an early age, it never matters how much you can invest. Even though you invest in small amounts of money in a disciplined regular manner, you can achieve a significant corpus of money over time.
Power of Compounding and mutual funds
We have seen the benefits of investing a fixed amount in a disciplined regular manner to get benefit from compound interest. But there is another big question to be addressed Where can an investor invest his money to get the full benefit of compounding?
The simple answer is mutual funds.
If you Want to know more about Mutual Funds Click Here
As an investment instrument, mutual funds are designed to get the benefits of compounding. This is most likely possible with Systematic Investment Plans (SIPs).
Here’s how it will work; you can invest a fixed amount of money in mutual funds at regular intervals by a Systematic Investment Plan (SIP). The regular interval can be monthly, quarterly, or semi-annually. You can select the amount of your choice as per your financial level, you can use a SIP calculator to calculate the total return on your investment and start a SIP payment on the preferred date. Investing at regular intervals in SIPs could multiply your returns over time.
There are many fund types in which you can invest in a SIP manner, you may need to consider investing in the fund which invest in Equity for long-term goals such as retirement planning, child education, child marriage. The equity funds have a great potential to give a great return for a long-time period.
The best thing about the SIPs is that you can set an automatic transfer request for your bank to transfer your funds from the bank account to the mutual fund directly every month or your preferred interval, thus decreasing the problem of reminding to transfer funds manually.
Key Rules to Enable the Power of Compounding
- Manage and control your expenses and try to reduce them.
- Try to start at an early age.
- The rule of compounding works in the same manner whether you invest Rs.1000 or Rs. 10,000. However, if you start investing a considerable amount, the interest you earn will also increase remarkably.
- The better way to utilize the real power of compounding is by raising your investments. In case of your limited income, you should try to increase your savings by having control over your expenses. Another way is to create a specific budget and identify areas you can decrease your expenses and costs each month. Spending smartly can increase your chances of savings and also chances of investing more. By following this way, you stand a chance to earn a good return and also to use the full power of compounding.
Also Read : The Top 2 Books Summary About Investing
The Major Rules
- There is nothing like starting investments at an early age. Ideally, it means should start investing as soon as after you start earning. But if you have crossed that stage, the best thing is to begin investing now. Identify a mutual fund that suits financial goals and start investing. When you start early investing, you can procure a solid base for your funds to grow and expand in the future with the help of the principle of compounding.
- Marinating discipline is another hard task because it is not for a year or two, it is for decades, you should remain invested so you should maintain good discipline and never break the rules.
- Another big task is to maintain patience because most of the humans fail to maintain patience due to which they lose many things, the same rule applies here you should have great patience because we are not talking about investing for a year or two, it is the matter of decades.
- Most of the people have agreed to get quick returns. But in the process of earning quick returns, they will definitely make mistakes that may result in big losses. As we have seen, the full power of compounding works over time. Thus, one should invest patiently which can earn you good returns over time
You do not need to expert or pro in the field of finance to get the benefits of compounding. Everyone who can invest wisely and can be patient can take full benefits of this concept of compounding. So, start investing today to enjoy a great future and to meet your financial goals
No, There are many ways of making Compounding Income, Mutual Fund is one of them.
Yes, the Real Power of Compounding can be utilized if Invested from an early Age.
Most People underestimate the Power of Compounding, and when they find it, it has been very late. They understand that they would have made millions if they had Invested from an Early Age, and yeah, it is true that Power of Compounding can make you filthy rich, but it only asks Patience from you.
Also Read : 13 Ways to Earn Passive Income