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THERE IS a royal road to riches that every investor, however small his savings, can travel on, safely and surely. And the vehicle that lets him accumulate wealth over time is run by a powerful engine: compounding.
What is it? Compounding is a simple concept that offers astounding returns: if you park your money in an investment with a given return, and then reinvest those earnings as you receive them, your investment grows exponentially over time. With simple interest, you earn interest only on the principal (that is, the amount you initially invested); with compounding, you earn interest on the principal and additionally earn interest on the interest. In other words, it’s a way of making your money work harder for you, and is perhaps the most powerful tool that an average investor can use to plan for many of life’s financial goals, including retirement.
Consider what the power of compounding does to an investment of Rs 12,000 a year (that is, an affordable Rs 1,000 a month) in a scheme that offers a conservative 9 per cent return, over 30 years. The total investment of Rs 3.6 lakh (principal) grows to Rs 17.83 lakh over that period.
For the long haul. Compounding rewards disciplined investing and works best over long tenures. In the above example, the first 20 years yield just Rs 6.69 lakh. The last 10 years show the money multiplier effect of the power of compounding. The longer you leave your money untouched, the faster and bigger it grows. For instance, stretching the above investment pattern to 40 years will give you Rs 44.20 lakh.
Two other variables–the principal and the rate of return–determine how much your investment will grow to. Even a one-time investment of Rs 50,000 over 30 years at 9 per cent compound interest will yield Rs 6.63 lakh. Likewise, if the returns are lower by even 1 percentage point, the investment of Rs 12,000 a year for 30 years yields only Rs 14.68 lakh. Over 40 years, the difference is even more pronounced.
The earlier, the better. The earlier you begin investing, the greater your gain from the merits of compounding. For instance, if you begin an investment plan at age 30 and invest Rs 10,000 a year for just 10 years at 9 per cent a year, and roll over the proceeds until you’re 60, you’ll get Rs 9.28 lakh on a total investment of Rs 1 lakh. On the other hand, your colleague who begins saving at age 40 and invests Rs 10,000 a year for 20 years at 9 per cent a year will only get Rs 5.58 lakh–on a total investment of Rs 2 lakh. That is, by allowing your money to compound longer, you can be richer than your colleague by Rs 3.70 lakh, although you saved only half as much as he did.
The mathematical equation for calculating the maturity amount (A) of a principal amount (P), invested at a given rate of interest (r) for a specified number of years (n) is: A = P (1+r)n
This tool shows you the astounding power of compounding. This is really an eye opener if you don’t invest systematically
Time as an investment ally. Compounding, thus, is a wonder tool that lets you make the most of small investments made over long periods of time to accumulate phenomenal wealth. It works best if you start investing early, and leave the money alone. Compounding is, in fact, the single most important reason for you to start investing right now. Every day you are invested is a day that your money is working for you, helping to ensure a financially secure and stable future.
Regardless of where you choose to put your money – cash, stocks, bonds, or a combination of these – the key to saving for the future is to make your money work for you. This is done through the power of compounding.
Compounding investment earnings is what can make even small investments become larger, given enough time. You are probably already familiar with the principle of compounding. The money you put into a bank account earns an interest. Then, you earn interest on the money you originally put in, plus on the interest you have accumulated. As the size of your account grows, you earn interest on a bigger and bigger pool of money.
The real power of compounding comes with time. The earlier you start saving, the more your money can work for you. To attain certain amount of corpus within a set period of time, a pro-active investment style is preferable. Thus, no matter how young you are, the sooner you begin saving for the future, the better it is.