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”.
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?
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...
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.
Start early to take advantage of compounding and grow your wealth
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.
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.
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.
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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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.