Time is the most valuable asset when we speak of investments. As an investor, you have to agree to this paramount factor before you begin your financial planning.
Investors are of two types – those who understand compounding and those who think they know compounding. Investors with knowledge of compounding will benefit when they choose long-term investments.
On the other hand, investors who think they understand compounding often make mistakes and lose a considerable portion of their money by churning their portfolio.
Only a few who possess common sense, basic arithmetic, keen observation and above all discipline & patience understand this point and reap benefits than others.
What is compounding?
Compounding as we learn is the addition of interest added to the principal amount of an investment. The added interest also earns interest and the process repeats until the date of maturity of the investment.
In even simple words, compounding is the process where you add the interest of an investment to the principle amount, which also becomes part of the investment in the next cycle/period and begins generating returns.
The concept compounding starts reaping higher amounts after a few years. Therefore, a long-term investment gives you fruitful rewards.
You will probably hear the term ‘compound interest’ than compounding. Although there is an addition of the word ‘interest’, the technique remains the same for all the forms of returns.
The accumulation of the interest to the principal amount contributes to a notable amount that adds value to the total investment. The longer the period of the investment the more money you accumulate because of compounding. Therefore, it is crucial to begin the investment process at an early stage.
Compounding refers to the reinvestment of the income that you earn from your investment. The rate of return continually grows due to its addition to the principle amount.
The simple example for compounding returns is the cumulative fixed deposits. In these investments, the total interest that you earn for a period exceeds the rate of interest multiplied by the deposit period.
You will often come across advertisements by borrowers such as banks, finance companies, and manufacturing companies, who promise returns that are excess than the prevailing interest rates.
Such advertisements are misleading because they refer to the simple interest that you will earn during the investment period and not the ‘rate of interest’ that is the compounding rate for each year.
Understanding this critical investment technique will help you plan all your future investments with caution.
You have often worried about the rate of interest. You search for policies and investment options that give you higher interest rate. The fact holds true as it makes a significant difference to your wealth over a period.
However, if you consider the power of compounding, the advantage lies in the benefit that the interest earned for a period adds to the principal amount of the investment. The process continues until the fixed period of investment. By the time the investment reaches maturity, the initial investment surpasses the actual return. The Higher rate of interest increases the principal amount in geometric proportions.
The following is an illustration that gives you an idea about the growth of investment at a various rate of return. You will receive 5% for leaving your amount in the savings account.
10% is what you receive for a one-year fixed deposit. You are bound to seek a return of 15% by choosing risky fixed deposits offered by a few companies. However, you receive 20% when you choose to invest in equity shares. The invested amount is INR 100.
The above example clearly portrays the power of compounding. It will be tough and waste of time when you invest your money in a low-income investment programs.
You will probably understand that ‘Time’ is the magic element for compounding. When you consider compounding for shorter lengths, you may not receive earth-shattering differences in comparison to the investment made.
However, you will benefit from it when you choose a long-term program such as 20-25 years. The interest earned for each year and its addition to the principal together account for a greater return at the time of maturity.
The longer the period of the investment the more you accumulate. It is the reason you have to begin investing in compounding programs at an early stage. The return on financing is in the form of dividends and capital gains.
Reinvesting the profit for each year and distributing across the investments increases the value of the portfolio, which, in turn, upsurges the interest earned each year. Similar to a snowball, the invested value takes the path of the growth, which is the result of the addition of earnings from each year that add to the principal amount. As time passes, the interest earned on the investment exceeds the initial principal investment.
The following example describes in detail about the impact of compounding interest for a long-term investment.
Let us assume that Mr. X invests INR 15 lakhs in 2015 for an investment period of 15 years and earns a nominal 12% on his investments. Therefore, the final investment capital is INR 15 lakhs. Any idea what his final corpus is? Hold your breath. It is Rs 2,08,76,640/-
The accumulated amount grows drastically, and the interest earned surpasses the initial investment within a short period.
Let us assume that you begin investing at the age of 25 years. You start with INR 200 a month in a tax-deferred plan that earns 9% per annum. Your friend invests in the same program at the age of 45 and invests twice the amount you pay – INR 400 a month.
When both reach the age of 65, the final amount towards the investment is INR 96,000. However, the investment value you hold stands at INR 8,84,000 while your friend’s is at INR 2,68,000. The reason behind this is that you began the investment at an early stage and the addition of earnings of the 20 years of compounding.
So we can go on and on..Hope you have got the idea by now. Start investing now, even if it is small amount and reap the benefits of Power of Compounding.