Power of Compounding in Investment

In the ocean of finance, an oft-repeated and widely valued wave is compounding. Creating wealth is an art, you cannot accumulate wealth by earning windfall income once by speculation or gambling. It can only be attained by skillful handling of one’s resources. No matter how small an amount you set aside, it all gets accumulated in the ocean you want to see. We all tend to ignore the power of compounding which is the only accelerator of building up a great corpus.

It really feels great when our money works as hard to grow as we did to earn it! Well, this can be accomplished by the magical concept of compounding. It is also worth noting that Albert Einstein referred to compounding as the 8th wonder of the world, He said: “The magic of compounding lies in the fact that it can help investors multiply their returns over the long-term”.

Compounding is a simple concept but very powerful. It is powerful because it acts as a multiplier effect. Basically, compounding is a process of earning compound interest on your investment. The interest earned on the principal amount is reinvested, so that, from that moment on, the interest that has been added also earns interest, this is called compound interest. Your investment will, therefore, generate earnings from not only the initial principal invested but also the subsequent interest earned over the coming period.

Compounding is basically a long-term investment strategy. The process requires two things to work, – reinvestment of earnings and time. When you decide to reinvest the interest earned on an investment, your returns themselves start earning. Thus, you are effectively converting your investments into an income-generating resource where your money is working for you to generate wealth. The “power of compounding”, has the ability to generate enormous returns, if invested in the right assets.

Let me make it simple with an example of two persons, one of them starts investing an amount of INR 1,000 at the age of 25, but the other begins at 35. Assuming a rate of return of 12% compounded annually for both of them, by the time they are 50, the former would have accumulated an amount of INR 17.9 lakhs while the latter would have accumulated only INR 5 lakhs! Therefore, the sooner you start investing, the more time you will have to reap the benefits of compounding.

Compound interest can be calculated with a simple formula.

Let me make it simple with an example of two persons, one of them starts investing an amount of INR 1,000 at the age of 25, but the other begins at 35. Assuming a rate of return of 12% compounded annually for both of them, by the time they are 50, the former would have accumulated an amount of INR 17.9 lakhs while the latter would have accumulated only INR 5 lakhs! Therefore, the sooner you start investing, the more time you will have to reap the benefits of compounding.

A = P (1 + [ r / n ]) ^ nt

These variables indicate:

A: The final amount
P: principal amount also known as your initial deposit
r: the annual interest rate, in decimal format
n: the number of compounding periods per year (for instance, monthly is 12 and weekly is 52)
t: the amount of time that your money compounds (in years)

Example: You have 1,000 INR earning 5% compounded monthly. How much will you have after 15 years?

  • 1. A = P (1 + [ r / n ]) ^ nt
  • 2. A = 1000 (1 + [.05 / 12]) ^ (12 * 15)
  • 3. A = 1000 (1.00417) ^ (180)
  • 4. A = 1000 (2.11497)
  • 5. A = 2113.70

After 15 years, you would have nearly 2,114 INR. Your final number may vary slightly. Here, 1,000 INR is your initial deposit, while the remaining 1,114 INR is interest.

  • 1. How is compound interest calculated in SIP?
  • Let's understand with an example. Assuming Pavan started investing INR 2,000 every year at the age of 19. Upon reaching 27 years of age, he stops investment and locks all his investments till retirement. Nidhi, on the other hand, does not invest until 27 years of age. At 27, she starts investing 2,000 INR every year till the age of 58. You will see that Pavan makes more returns on the whole.

  • 2. What is the 15*15*15 rule in a mutual fund?
  • The 15*15*15 rule of mutual funds refers that if you invest INR 15,000 every month for 15 years for an annual compound interest rate of 15%, by the end of the investment period, you will have INR 1 crore with you against your total investment of INR 27 lakhs.

  • 3. How do you calculate interest compounded continuously?
  • Previously, when people had a bank account, every year their balance would increase along with a factor of (1 + r/4)4. Now it has become possible to compound interest on a daily basis as well as monthly basis. This means that the balance rising by a small factor upon each instance.

  • 4. How do you calculate interest compounded daily?
  • Financial institutions differ in terms of their compounding rates on a daily, monthly, yearly basis. For instance, savings account with the principal amount 1000 INR and 10% interest per year known as compounded yearly would have a balance of 1100 INR by the end of the first year.