Financial Literacy

The Power of Compounding

“Money doesn’t grow on trees!” we’ve been told all our lives. But money and wealth do grow. They can be grown!

Did you or someone you know have a piggy bank as a child? If you did, do you remember the wonderful feeling of opening or breaking it once it was full? The joy of counting the money was quite something else, wasn’t it? It’s the biggest testament to the saying “little drops make the mighty ocean”.

A girl smiling and putting coins into her piggy bank.
The concept of the piggy bank seems insignificant, but actually it’s quite powerful

As we become adults, the piggy bank changes form. Avenues such as Fixed Deposits (FDs), Recurring Deposits (RDs), stocks, bonds, and commodities come to take its place. But have you ever wondered as to why we switch from saving to investing as we grow? Well, the simple answer is that we want our money to grow not remain as it is. And this is what differentiates investing money from saving money in piggy banks.

Our money has the potential to grow enormously owing to the principle of compounding.

We’ve all solved arithmetic problems on simple and compound interest in school. But it’s likely we wouldn’t have understood what compounding can do for our money in real terms back then.

Let’s understand what compound interest is and how we can use it to grow wealth.

What is compound interest?

Image showing stacks on coin increasing in size and then becoming a jar full of coins with a plant growing from it. There is an arrow to indicate the jagged growth that takes place when money compounds.
The power of compounding is what prompted Albert Einstein to call compound interest the 8th wonder of the world

Compound interest is the interest calculated on the initial principal, which also includes all of the accumulated interest from previous periods.

The word ‘compounding’ itself means that the interest earned on the principal is reinvested or in other words, it is considered as fresh, invested capital. Owing to this, compound interest helps us earn money even on the interest earned during previous years. Hence the added benefit provided by compound interest over simple interest is the ‘interest on interest’.

Compound interest therefore helps us earn much greater returns on our invested amount due to the loop or chain effect which extends gains on interest earned as well.

How does compounding grow money...

Concept of power of compounding where the principal earns interest and gets added back to the principal.
The power of compounding can be used to make a huge fortune with little savings over an extended period of time

Let’s look at a practical example of how compounding works.

Suppose there are two friends Sheela & Ben. Both invest ₹ 100000 at 7% per annum for 5 years. But Ben chooses interest to be calculated as simple interest, while Sheela opts for compound interest. At the end of 5 years, Ben gets ₹35000 as interest whereas Sheela gets ₹ 40255. The compound interest helps her gain the extra benefit of ₹5255.

This is the major difference between compound and simple interest.

Compound interest reinvests your interest earned at the existing rate which helps earn additional returns.

Look at the graphs below to see the increase in returns over time.

Graph to show growth in interest over 5 years to highlight the difference between simple and compound interest.
Graph to show growth in interest over 10 years to highlight the difference between simple and compound interest.
Graph to show growth in interest over 20 years to highlight the difference between simple and compound interest.

Start early to take advantage of compounding and grow your wealth

Financially successful business man sitting in chair and relaxing with his legs on a huge piggy bank. It's an image to represent financial security and contentedness.
The power of compounding is highly dependent upon time; the younger one begins the more profitable

Time is of the essence when it comes to the phenomenon of compounding. Hence, the earlier you begin, the more you stand to gain. As the saying goes, the early bird catches the worm, in the same manner, the early investor reaps more benefits and grows their wealth by investing their money in different avenues.

To use the same example, ₹100000 invested becomes ₹140255 in 5 years. However, if the same money is invested for 10 years, the return is ₹196715. If you increase the time further to 20 years, the amount becomes ₹386968. So someone who starts earlier, at the age of 20-25, can stay invested for a longer period and get very good returns during their late 40s.

A young woman sitting at a desk in front of her laptop looking up smiling with her fists closed in the air to indicate victory. It indicates growing one's wealth in the younger year's of life.
Investing in your 20s is a great way of securing your future; however, it’s never too late

Be patient and disciplined

However, we often forget the most simple rules for investing money: being patient and disciplined. No no, don’t underestimate the value of these two virtues when it comes to investing.

Human beings today have gotten so used to instant gratification, that deferring our expenses for reaping greater benefits at a later stage in life takes quite a lot doing. The whole discourse for the youth is based on the mantras of ‘YOLO’ or You Live Only Once and ‘FOMO’ Fear of Missing Out. Both these mantras can be detrimental to the saving and investing mindset as they are both geared towards instant gratification. However, all successful people will tell you the value of delayed gratification.

Representative image of a traditional weighing scale with NOW on one side, and LATER on another. LATER is heavier, indicating that when we delay our gratification, it has more weight and count more towards wealth creation.
Patience and self-discipline are key to delaying gratification, which is the basis of clean personal finance habits

We also need to understand that making money through the compounding effect is like a process working behind the scenes for you. It is not a milestone that can be reached by driving fast. Starting early and choosing right set of investments can help prevent accidents.

Photograph of Warren Buffet sitting at a table with a crowd behind him. He is speaking on the microphone and has his hand raised in mid-air explaining a point.
Warren Buffet, the investing giant of the world started investing at 11 and possesses a distinct feather in his cap for maintaining a whooping Compound Annual Growth Rate (CAGR) of 20% over 50 years

Conclusion

The key motivation for investing money are the huge returns we hope to obtain. We can utilize these returns for fulfilling many of our life goals.

Compounding can help us to grow your money and wealth exponentially over time. No matter, where you are investing whether it is an equity stock or a fixed deposit, compounding results in multiplying your money.

The underlying difference is that fixed deposits are a secure means of saving money with a pre-defined rate of interest. In comparison, returns from equity depends upon the stock market. Instead of compounding your money, we also risk losing the money that we have already invested.

The power of compounding is an ultimate gift of finance which can help us to retire early, plan our children’s education and marriage, undertake foreign trips, and fulfil many other dreams.

The secret code for winning the compounding game is focusing on the rate of interest, the time duration, and the applicable tax rates. So start early, calculate your risks before investing, make a note of the interest and tax rates, and invest with long term-horizon. Lokyatha is here to help!

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References:

https://www.thecalculatorsite.com/finance/calculators/compoundinterestcalculator.php

https://www.investopedia.com/terms/c/compoundinterest.asp

Resources:

For calculating interest on recurring deposits: https://groww.in/calculators/sbi-rd-calculator/

Disclaimer: This article is for educational purposes only. It should not be considered financial or legal advice. Please consult a financial professional before making any significant financial decisions.