Power of Compounding

How to Grow Your Wealth Over Time?

Compounding is a powerful financial tool, and it makes your savings grow exponentially over time. It helps in increasing your income potential effortlessly. Compounding simply means reinvesting your investment earnings on an annual basis rather than spending them right away. 

Let’s explore how you could use this technique to achieve your financial goals, such as saving more money for higher education, the marriage of children, or retirement.

Compounding - What it Means for Your Investments?

Compounding is an infinite process that allows you to make the most of your money by generating earnings from previous earnings. Reinvesting your gains generates more returns on its own, producing a snowball effect. It can be understood as a financial phenomenon where previous investment earns additional income or creates future potential as well because it builds upon itself with each successive period. The process leads to exponential growth as each round produces multiplying effects.

The key to compounding is reinvesting the money. When you invest, you tend to count on your earnings, but you can earn more than expected if you invest your profits. The strategy is known as compounding. It simply means making small investments and then investing your profits from those for higher gains.

How Opting for Compounding is Wiser?

When you invest, you can earn interest in two ways. One is simple interest that generates regular returns and the other is compound interest, which improves your returns manifolds. 

Let’s deep dive into the concept by comparing both types of investments- 

i. Simple interest is calculated using the following formula:

Simple Interest = Principal X Rate of Interest X Time (in years) / 100

The simple interest calculated is added to the principal amount to get the maturity amount. 

ii. Compound interest is calculated by including the Principal amount each time, so the formula is-

Compound Interest = Principal (1+ Rate of Interest/100) time (in years)

You can further explore the power of compounding with these examples. 

Let's assume you have Rs. 100,000 and it is divided equally, i.e. Rs. 50,000. You invest the money in two schemes, one that offers simple interest and the other on compounding interest.

As shown in the above table, at the end of 10 years, you will accumulate a corpus that is Rs. 29,687 higher than gained through simple interest. The difference in the calculation is because of compounding, the interest you have earned in the previous period was included in interest computation for the next period. 

The power of compounding has helped your savings grow over the period of 10 years. The interest earned each year was added to the principal amount for calculations. When investing in a simple interest offer, the returns are limited however, with compound interest, you can earn much more.

Compounding Parameters That Impact Wealth Accumulation

Many factors influence the rate of your accumulated wealth. The following parameters will affect it in some way or another:

1. Rate of Interest: It is important to consider the rate of interest before investing your money. A difference in interest rates can make a big difference in your returns, so it's essential to carefully consider which options will offer you higher earnings at the end of an investment period. Investments such as stocks, ULIP policies, and mutual funds are a great way to build wealth for the future. They can offer high rates of return while being an appreciating asset. 

To simply understand this, assume you have Rs. 500,000. You have invested it in five different investment schemes for 10 years and will earn compound interest in all of them. 

The result varies for each investment instrument, as the rate of return per annum is different. 

2. Time Duration: Compounded returns can be really exciting, but they're equally tricky to understand. Investors need to think about the regular return on their investment each year and calculate how it adds up over time. Every additional interval from an initial period of compounding will make a huge difference in your final maturity amount. It clarifies why so many people choose long-term investments like retirement funds or bond funds. Some investments, such as fixed deposits, can give you a high return over long periods of low risk. The key is not to disturb your investment too early and let it accumulate for longer intervals. 

For example, you invested the same Rs. 500,000 at the same rate of interest, i.e. 10% per annum for different tenures.

The returns generated will be highest for the long-term investments as the compound interest is earned for each term of your investment.

3. Frequency of Return - The frequency at which your investment is compounded increases the likelihood of earning a better return. Therefore, to earn a substantial amount from your investments, it is best to invest your money in schemes that pay interest more frequently. It means a shorter compounding period on investment improves the chance of you receiving higher returns over any period of time.

4. Tax Liability - You are liable to pay taxes on your investments and tax calculation affects how quickly your wealth grows. The amount of tax payable will be calculated depending upon your rate of interest and frequency of compounding. The maturity amount on your investment will be higher if the tax is applicable at the end of the compounding period. 

How You Can Benefit from Compounding?

Compounding is a powerful tool useful when investing. Bank Fixed Deposits (FDs) are an example of compounding where you let the interest accumulate throughout the FD tenure instead of withdrawing it each month. This allows you to accumulate a larger corpus by giving a higher amount as the result. Mutual funds have become successful investment options by making use of this powerful concept. All profits earned from mutual fund schemes are reinvested by the Fund Manager to generate more profit over time. Dividends are a percentage of the total amount invested in which is given back to investors every year on their investment. While growth investments can be made by either a lump sum or in instalments over time for future returns, their performance will depend on how well the mutual fund performs. 

Prerequisites to Gain from Compounding on Your Investments

To reap the benefits of compounding, you need to follow a proper strategy. You must calculate and compound your returns on investments by understanding the following principles: 

• Spending less than you earn. 
• Investing for growth while acknowledging drops in return during periods of economic uncertainty. 
• Not touching principal without sacrificing at least some potential earnings so that interest can be earned over time.

To gain all the benefits from compounding, you must take the following steps-

1. Start early - You must consider investing some money as soon as you start earning. That is the best way to take advantage of compounding, which requires time. If you get started early with even a small amount saved for investment, then it will generate better returns than investing a large sum later on. By that time your money would already have been reinvested and grown exponentially.

2. Stay disciplined - To develop a healthy portfolio, it is important to identify your financial goals and be disciplined. Many investors miss out on the benefits of compounding because they lack a disciplined investing plan. Consistent investments towards defined objectives are key to successful returns on investments over time. 

3. Allow time for growth - We wish for quick returns, but patience is the key. Long-term investments reap the most from compounding. You will have to let your investments grow over years to collect a healthy lump sum capital over years. Investors should be patient and avoid making any hasty decisions during volatile market conditions. The smallest investment can have a significant impact on returns, so it's important to wait for the right time instead of cashing out early.

Takeaway

When you invest money, it is not just the initial amount that counts. It’s also how much your investment earns over time through reinvestment. The power of compounding can grow your wealth exponentially which is why opting for investment instruments that pay compound interest might be wiser than most investment options. Various factors decide on whether compounding will work in accordance with your future goals, so make sure to look at all the variables to invest smarter.