Make Your Money Work For You With The Power Of Compounding

20 Dec 2022
5 min
Share

Do you ever wish to save more for the future? Or are you worried about running out of money? You can accomplish both of these things by knowing how to apply your money to work for you. Even if you begin small, you can aim to achieve enough in the long run. How does all of this occur?

It is the power of compounding working behind the scenes.

Your daily activities have a compounding effect as well. Whether it's reading, meditating, eating vegetables, or practising yoga..."

You build on what you did today, the next day. You start the next day a little better, perhaps so slightly that you can't even tell, than you did the day before. However, the results can be massive when these increments are added over time.

Similarly, compounding is the process by which earnings in the form of interest or profits is reinvested to generate additional earnings over time. What is the source of this incredible compounding power? It is time. The longer you keep your investment, the more interest or profits you could earn on your investment. Compounding has the potential to help you grow your money exponentially over time. You don't have to be wealthy to invest, but the magic of compounding can make you wealthy.

Albert Einstein once said, "Compound Interest is regarded as the world's eighth wonder. Whoever understands it earns it, and whoever does not pays it."

How does compounding work?

To understand how compounding works, imagine you have invested Rs 10,000 in an investment (say bank deposit) that pays a 10% (hypothetical figure) yearly return rate.

Your total investment would be Rs 11000 at the end of the first investing period (a year in this case). That is, 10% of Rs. 10,000 equates to Rs. 1,000 in interest, which is added to the principal amount. Compound interest comes into play only after the second year to generate the interest needed to reinvest.

At the end of the second compounding period, the increased principal of Rs 11,000 grows by 10%, resulting in an overall gain of Rs 1100. This brings your total gain to Rs 12100. Both the principal and the interest earned have increased in this case.

Compounding in mutual funds works exactly as discussed but is trickier than compounding in a bank deposit.

Let us understand this with an example

Mr. Jo began investing Rs 5000 per month in a SIP for retirement planning at the age of 25, whereas Ms. Blush started investing Rs 5000 in the same SIP at the age of 35. Both A and B invested until they were 55 years old. So, during the course of the tenure, Jo invested Rs 18 lakh and Blush invested Rs 12 lakh. Let us assume the same expected rate of return of 8% p.a. for each and examine how much corpus they accumulated at the conclusion of the investment term.

If we compute the corpus for Mr. Jo at the age of 55, it would be around Rs 70 lakh, and for Ms. Blush, it would be around Rs 28 lakh. The entire investment difference between Jo and blush was only Rs.6 lakhs. Despite investing the same amount, Jo's corpus is nearly 2.5 times that of Blush. What has worked in Jo’s favour is the investment period. Jo was able to create a financial corpus worth Rs. 42 lakhs more than Blush by starting 10 years earlier.

There is no such thing as a rising return value. It is the value of your stocks that is compounded. But bear in mind that the stock market is a fragile place to invest; you can also lose money.

The above investment simulation, based on assumed rate of return(s), is for illustration purpose only and should not be construed as a promise on minimum returns and safeguard of capital. Union Mutual Fund is not guaranteeing or promising or forecasting any returns. SIP does not assure a profit or guarantee protection against loss in a declining market. Entry/Exit load is not taken into consideration in the above investment simulation.

 

How to leverage the power of compounding?

It is critical to leverage the power of compounding to our greatest advantage as soon as possible. Here are some crucial considerations to remember when using compounding to your advantage;

1. Maintain Discipline:

There is always an excuse to stop investing or to stick to the amount you started with. However, if you truly want to benefit from the power of compounding and build your wealth to attain your financial goals, you must be disciplined in your investment decisions.

This means you must begin your investment journey and invest regularly. Even though the returns are volatile, one should be active to increase the investment amount.

 

2. Start Early

Ideally, you should begin investing as soon as you start earning a living because the earlier you begin, the greater the benefits. Also, start early for a longer investment period because compounding works best when you start early and stay invested for the long run. Extend your investing window and reap the benefits of compounding.

The advantage of starting early is that even if you invest more money or get higher returns later in life, it will be difficult to catch up to an investment started earlier in life. This wasted opportunity is known as the cost of delay, which can significantly impact your compounded returns. However, even if you still need to start that early, now is the time to start.

 

3. Develop a habit

Commit yourself to a habit of investing for a better and wealthier future. Begin investing and stick with it.

 

4. Patience is the key

 Maintain your composure and patience. Do not be alarmed if the market falls temporarily. You must understand that building a corpus that can assist you in reaching all of your financial goals will take time. You may refrain from making regular investments due to personal biases or market environment changes. However, to profit from the power of compounding and potentially create the desired returns, you must possess the patience to stay invested for the long term.

 

To conclude, the advantages of the power of compounding are enormous: you may maximise your savings and investments to support your long-term financial goals. As an investor, it is vital to begin investing as early as possible, set goals, be disciplined, and possess a lot of patience, as compounding requires investments to be held for the long term. Compounding can help you create even more wealth if you invest right away. Several investment alternatives in India, including fixed-income and market-linked products, can provide compounding rewards.

 

Mutual fund investments are subject to market risks, read all scheme related documents carefully. The information in this document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipients of this material should rely on their investigations and take their own professional advice.

gray picture

Want a hack to successful investments? Hint: The key is patience.

Know More

Articles you may like