Intermediate

Small steps today can alter the course of your financial future in incredible ways. This, in a nutshell is the power of compounding, often, referred to as the 8th wonder of the world.

Compounding is the process in which interest is calculated on an initial principal sum of money and then further interest is earned on the accumulated interest as well. Compound interest can be thought of as “interest on the interest”, or in the case of investment funds, as “return on the returns”. Simple interest (when interest is paid out to the investor), is the interest calculated only on the principal amount. In case of simple interest, there is no change in the principal amount; however, in compounding, the principal also continually increases over time as all interest installments are added back to it (and not paid out to the investor).

Compound interest versus simple interest

When you use compounding, you end up earning a higher amount of interest than you would in case of simple interest.

Lets us understand this better with an example. Consider a single investment of Rs.10,000 @ 8% per annum. Now in compounding, the interest you earn every year gets added to your principal, which in the next year will increase your interest return.

This is demonstrated from the example below:

In this example, you can see that simple interest is paid on the principal only, and not on the principal plus the accumulated interest. Compound interest is paid on the principal plus the accumulated interest since the money is retained in the investment.

The effect of additional returns that compounding can provide is one of the major reasons why it is recommended to begin investing as early as possible and investing regularly over the long term.

Investing early and the benefits of compounding

Here is an example to demonstrate how starting with your investments early in life will help you benefit from compounding.

Let’s say you are 25 years old, and invest a modest Rs 6000 annually @8% per annum. And a colleague of 45 years invests Rs 12000 annually at the same return rate.

As you can see from this illustration, compounding is a very compelling proposition. In this scenario, you who are 25 years old can build a retirement fund of Rs 15.54 lakh by the age of 65 through regular saving of a modest Rs 6,000 per annum for 40 years while your colleague who is 45 years old, after 20 years of investing Rs 12,000 per annum, will finish with a modest corpus of about Rs 5.49 lakh. Your colleague - the 45 years old ends up with less than half the corpus accumulated by you - the 25 years old - in spite of investing double the amount, just because he started investing later in life.

Therefore, even investing smaller sums of money at an early stage of your life you will have a larger overall pot of wealth than if you started investing large sums of money at a later stage in life.

Invest regularly over the long term and the benefits of compounding

Here is another example to demonstrate how investing regularly over the long term will help you benefit from compounding.

Supposed you invested 10,000 per month @12% per annum, you will have over Rs. 23 lakh in 10 years, Rs. 1.88 crore in 25 years and if you stretch for 35 years, your investment of Rs. 42 lakh, would give you a corpus of Rs. 6.43 crore. Which means that between your 10th and 35th year of investing, on an investment of Rs 30 lakh more, your returns will grow by over Rs 6.2 crore. This is over 20 times that of your additional investment!

This also means that even a little bit of delay in starting to invest could potentially cost you a lot of wealth over the long term, since your money will now have a shorter period of time to grow.

The power of compounding, combined with the idea of starting to invest early and regularly over the long term, can almost be thought of as the golden triangle of investing masterminds. These three, when they work together, can do astonishing things for an astute investor.

Consult an investment advisor to know more about compounding.