Know how the power of compounding works
Imagine a snowball rolling down a mountain. What will you see? As the snowball rolls down the mountain, it gathers snow and becomes a bigger ball. Compound interest does the same thing to our money. Compounding is a simple way that will help you to grow your money at an exponential rate over a period of time.
What is compound interest?
Compounding is said to take place when the returns or interest generated on the principal in the first period (a year or a quarter) is added back to the principal amount to calculate the interest for the next period. The process continues until you stay invested. Simply put, compounding means receiving interest on the interest earned in the previous periods.
Why is compounding important?
We all work hard to earn money. But is the money working hard for us?
There are two types of interest or returns given by financial products: simple interest and compound interest. Your money will work hard for you if you invest in financial products that work on compounding. Mutual funds and equities help you to compound your investment amount. On the other hand, the interest rate given by your bank on a savings account is simple interest.
Let us see how your initial investment of Rs.50,000 would grow in 5 years at 8% simple interest rate and compound interest.
Rate of return
Hence, we see that through compounding, you can earn more interest and accumulate higher corpus.
How does compounding work?
The most crucial factor in compounding is time. It is because as your investments start generating returns, it will help to increase your corpus at a faster rate. The longer you stay invested, the higher will be the effect of compounding.
Let us take an example where Rs. 1 lakh is the principal amount and rate of return is 10%. Let’s see the effect of compounding from a 30-year time horizon.
From the above table, we can see that Rs. 1 lakh grows to Rs. 1.61 lakh at the end of fifth year i.e. gain of Rs.61,000. Later, we see the growth in every five years is higher than the previous period. From 25th year to 30th year, the corpus grows by more than Rs.6.61 lakh in just five years. At the end of 30 years, Rs. 1 lakh becomes 17.44 lakhs, i.e. it has increased by more than Rs.17 lakhs in 30 years.
How to harness the power of compounding
We have seen that compounding makes our money work hard and help us achieve corpus. While most of us know the benefit of compounding, we are not able to harness the power of compounding. Here are three steps that can help us make the most of compounding:
1. Starting Early
Start as soon as possible. Delaying your investments by even a year will cost you. Hence, it is ideal to start investing when you begin your work life. In this way, you can grow your wealth faster and achieve your financial goals.
When you start investing, it is easy to panic over short term news or get tempted by a hot stock. This calls for discipline. You need to focus on your financial goals and ignore the noise.
3. Be patient
Most of us start investing for quick bucks. But, investment is a long-term endeavour. You should not lose your patience if your investments are not growing fast. Some things work best when left undisturbed.
This was all about the power of compounding. To know more, get in touch with your advisor.