The Power of Compounding or eighth wonder of the world, whatever you say, is the same thing. People may underestimate the compounding benefits, but believe me it add wonders to your money life.
But before we understand the benefits of compounding, let’s first understand the formulae and benefit of component of compounding formula and then conclude it with real life example of Mr. Bestii Singh.
Table of Contents
What is Compound Interest
Whenever we invest our money, whether we make an FD, RD, PPF, mutual fund or purchase a bond or lend money to someone, we expect to get some benefit over it. This benefit in percentile terms is called interest rate.
Simple Interest – If we get same amount of interest on our principal amount then it is simple interest. For example I invested Rs. 1 lac at an interest rate of 10%, then I will get Rs 10000 every year as interest amount.
But in case of compound interest from 2nd year I will get interest over 1.10 lac and not on 1 lac. This also mean the interest earned is added to the principal amount and I will get interest over composit principal amount( 1.10 lac).
In simple words in compound interest one get interest over interest.
Compound Interest Formula
The formula for compound interest, which represents the power of compounding, can be expressed as:
A=P(1+r/n)^nt
Future value of investment = Principal amount (1+rate of interest/compounding frequency)^frequency of compounding*time
A is the future value of the investment/loan, including interest.
P is the principal amount (initial investment/loan).
R is the annual interest rate (decimal).
N is the number of times that interest is compounded per year.
T is the number of years the money is invested/borrowed for.
Understanding compounding formula
There are the three very important component of the compounding formula:
Invested amount ( principal amount)
Whenever one wishes to get a good amount in the future, the above three parameters are most important.
If you notice, the higher the principal amount, the higher the maturity value.
100000*(1+12%/5)^5 = 112589
500000*(1+12%/5)^5 = 562950
Of course if one invests a higher amount, they will get a higher maturity amount.
But usually we do not always have control on the principal amount since we all have limited resources.
Time you give to your money to grow
Another very important factor is time. Do you also think you have little control over it? Yes, usually we have little control over time.
Now in line with above calculations only, let me elaborate it
100000*(1+12%)^5 = 176234
In the above example , we invested money for 5 years and compounding once in a year. Therefore nt = 1*5 i.e.5 only.
100000*(1+12%)^10= 310584
Now if you stay invested for 5 more years i.e.for 10 years
100000*(1+12%)^15= 547000
100000*(1+12%)^20=965000
Here, you can notice how investment of Rs 1 lac grew to Rs 1.76 lac in 5 years, Rs 3.10 lac in 10 years, Rs 5.47 lac in 15 years, Rs 9.65 lac in 20 years time.
No more evidence needed to prove time is important. Therefore, it is always sain Start Early investment. Since time matters a lot !
I think this is the one thing which is in our control.
Rate of interest
The other very important factor is the rate of interest. Just notice where the ‘r’ is written in the formula.
Obviously higher the rate of interest is the maturity amount. Therefore, one should invest in high interest products, so as to get inflation adjusted returns.
Compounding in simple words
When you earn interest over your interest, it is due to compounding effect.
At its core, compounding refers to the process of earning interest or returns not only on the initial investment but also on the accumulated interest from previous periods.
Bestii Journey to understand power of compounding
Let’s understand Mr Bestii Singh’s investment compounding benefit. He made the initial investment for Rs 1 lac at a rate of 10% per annum.
| Time | Principal Amount | Rate of interest ( annual) | Interest earned | Year end balance |
| 1 | 100,000 | 10% | 10,000 | 110,000 |
| 2 | 110,000 | 10% | 11,000 | 121,000 |
| 3 | 121,000 | 10% | 12,100 | 133,100 |
| 4 | 133,100 | 10% | 13,310 | 146,410 |
| 5 | 146,410 | 10% | 14,641 | 161,051 |
In the above table, Bestii invested Rs 1 lac and earned Rs 10000 as interest at the end of year one.
In year two his principal amount increased with Rs 10000 ( earned interest). So in the 2nd year beginning his principal amount turns to 1.10 lac instead of 1 lac. Now again he will earn interest on the increased principal amount and the interest amount increases as the principal amount is 1.10 lac.
In year 3, his principal amount became Rs 1.21 and he again earned interest of Rs. 12100 on this amount. Thus the year end amount reached to 1.33 lac.
Similar is the case in year 4 and 5. The longer Mr. Bestii Keeps his money in investing the better it is.
Power of Compounding in mutual funds
When Bestii Singh invested 1 lac in a mutual fund scheme in 2017. Its NAV was Rs 20/21 and today its NAV is Rs.21.
Now Bestii received units 1lac/21 =4762 units
Today its NAV is Rs 57
Which means
Bestii money value today is 4762 units*Rs 57 =Rs. 2,72,000
Compound interest 18.15%
Benefits of Compounding
1. Exponential Growth- The awesome benefit of compounding is the exponential growth of money. If you allow your investment enough time to compound, the growth curve gets steeper over time and your maturity amount increases. ( Notice the raise to power (time) in formula)
2. Wealth accumulation- Compounding is the powerful tool to increase wealth. Over the long run, you can dramatically raise your net worth by continually investing and letting your money grow.
3. Less Dependence on Timing -Unlike active trading or market timing, compounding doesn’t rely on timing the market. Regular contributions and time are the basic factors for successful compounding.
4. Harnessing Time- As said before also,the earlier you start investing, the more time your investments have to compound.
Even small amounts invested early can turn into substantial sums due to the extended compounding period.
5 Risk Mitigation- Long-term investing allows you to ride out market fluctuations, reducing the impact of short-term volatility on your overall portfolio. This can help mitigate risks associated with market downturns.
How to Maximise the Power of Compounding
1. Start Early- The earlier you start investing, the greater the benefits of compounding. Even if you can only invest a small amount initially, the time factor can make a significant difference.
Watch Video – why invest early
2. Regular Contributions- Regular contributions to your investments amplify the effects of compounding. Set up automatic deposits to ensure a consistent inflow of funds.
3. Increase Contribution Periodically- Periodic pocket friendly increment as SIP or one time additional contribution can also add a huge amount to your kitty.
3. Reinvest Earnings- Instead of cashing out dividends or interest, reinvest them into your portfolio. This accelerates the compounding process by letting your returns generate further returns.
4. Diversification- Spread your investments across different asset classes to manage risk. Diversification can help you maintain stable growth and prevent the negative impact of a single investment’s poor performance.
5. Long-Term Perspective -Patience is key. Let your investments compound over years or even decades. One should avoid taking impulsive decisions based on short-term market fluctuations.
Conclusion
Never underestimate the power of compounding. To reap out maximum advantage from compounding, Start Early, increase your contribution regularly, stay invested for long term aligned with your financial life goals. Invest in high return products, which give you better inflation adjusted returns.
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