What is the Power of Compounding?

The power of compounding has been used by investors to build a corpus of wealth over time. If you start your investment with an instrument employing the power of compounding, like a public provident fund account (PPF), you can grow your capital to a substantial amount over a period. In compounding with a PPF account, the longer you invest, the greater the value of your investment will be at the end of a specific period. Let’s dive into the power of compound and the implications it has for different investors. 

What is the power of compounding?

The power of compounding, if offered through any investment instrument, lets you grow your money over time. The power of compounding works its magic best when you invest for a long period compared to a short timeframe. It is a good way to invest for those investors who wish to create a retirement corpus, or for those who wish to meet long-term goals like financing a marriage, buying a home, or affording a child’s education. 

The way that compounding works in some investment devices is that it permits you to earn interest on an amount initially invested, as well as on the interest earned,[1] such as in a PPF account. However, you can avail of another compounding effect with a bank cumulative fixed deposit. Here, you invest an initial amount on which you earn a fixed rate of interest. Your money gets compounded as it earns a fixed interest for several years. You simply get the sum of interest payments at one time at the end of your investment tenure. If you go in for a deposit like this, you can use a power of compounding calculator to know your amount at maturity. There are some bank FDs that also offer the compounding effect of interest collected and interest on that, so your returns are higher. 

Hence, if you invest in a bank’s cumulative fixed deposit scheme, investing ₹1 lakh per year for 30 years at an interest of 5.5%, your final amount at the end of the investment period, 30 years, will be ₹76.4 lakhs (all the interest payments plus your initial deposit). The power of compounding acts as a summative tool. 

A bank fixed deposit may give you assured returns, and non-existent risk. However, as asset classes go, equities have shown better performance. Potentially yielding approximate rates of return at 16% in the long run, you may invest some of your capital here. Imagine if you earn an interest of 14% (assuming this is the rate) on the same principal mentioned in the fixed deposit example earlier, you can potentially gain ₹4.1 crores at the end of 30 years. 

Formula for Compounding 

If you want to check the power of compounding, calculator use online can help. With an online calculator, you can calculate how much interest you will earn on different principal amounts, as well as based on a variety of tenures. However, you can also use a compound interest formula:

CI = P (1 + R/ 100) N - P

Where:

P = Principal amount invested

R = Rate of interest

N = Number of years

To understand the power of compounding, and the amount of compound interest, all you have to do is substitute the corresponding values and use the formula. 

Example of Compounding 

Here is an illustrated example of compounding to help you grasp the concept better: 

Say, Mr. A has invested in a particular asset with the principal amount of ₹10,000 for 10 years. The interest rate that this investment will yield is at the rate of 7%. Therefore, the total interest that Mr. A will earn over 10 years works out to ₹20,097. 

How does compounding work in a fixed deposit? 

One of the safest and most popular investment channels is a bank fixed deposit. Fixed deposits provide investors with returns of a fixed nature and are free of risk in investment. Fixed deposits (FDs) are of two kinds: those that provide investors with regular interest payouts every month, quarter, or six months, and those that provide the total interest (summed up for the period of the deposit) at the end of a long tenure with the principal added. 

Typically, FDs that offer compound interest are called cumulative FDs, and the longer you invest in these, the more you can earn. The power of compounding in FDs may offer you stable returns and a large sum over a long period, but in case you wish to choose a potentially steadier route in equity investment, you may try the mutual fund path of investment. 

What is the power of compounding in mutual funds?

Today, with myriad investment avenues for investors, there is no dearth of choice. If you wish to diversify your financial portfolio and minimise your risk with a spread of investments, you may opt to invest in mutual funds. Additionally, you can experience the power of compounding in mutual funds. 

Investing in mutual funds offers you the chance to choose an investment in equity or debt-based funds or a blend of both. In a mutual fund, an investor typically deposits a lump sum of capital or a series of regular contributions via a Systematic Investment Plan (SIP). If you select a SIP, you can benefit from the positive effect of compounding at just a small portion of the investment amount. Contributions that investors make may be monthly, quarterly, or six-monthly. 

In any mutual fund, the power of compounding takes place, and returns are earned through capital appreciation. Over a long duration, mutual fund investment can prove fruitful, and investors may achieve a substantial corpus. 

The power of compounding in mutual funds can be understood by this example of a mutual fund investment through a SIP: 

Let us assume that Mr. K invested in a mutual fund via a monthly systematic investment plan with ₹2,000. The returns are clocked at 7% for 10 years. At the end of 10 years, Mr. K’s investment, according to the figures mentioned, would have collected ₹2,40,000, the total returns being at ₹1,08,189. If Mr. K were to invest more initially, say ₹5,000, then his returns would increase relative to if he had invested only ₹2,000. So, the more you invest, the more you get. The compounding of money through a SIP is a popular motivator for many investors today. 

What are the advantages of compound interest?

The key advantages of compound interest include the way you can accumulate a large corpus over the long term. The main advantages of compound interest are listed below: 

• Compound interest lets you earn interest on the principal capital invested, as well as the interest, depending on the instrument. This is the case with a SIP as your returns are reinvested and you earn interest on these amounts. 
• The interest generated through an investment with the power of compounding permits you to create a large sum over a long-term tenure. 
• Through a SIP, even small investors can partake in investments to grow wealth in a disciplined manner, contributing small sums towards their final corpus.
• Compound interest can grow money over a period, and you do not have to track your investment. 

Strategies for Maximising the Effect of Compounding 

If you want to take advantage of the potential of compounding, consider the following strategies when you invest: 

• Invest Early - By investing early, you can invest more, especially if you want to increase your invested amount through SIPs. Furthermore, when you invest early, you ensure a longer duration of investment with the power of compounding working optimally.
• Invest Consistently - To realise the full potential of the power of compounding, you must have a disciplined investment approach. Furthermore, investing regularly gives you the perk of rupee-cost averaging spread across a long period.
• Exert Patience - Once invested, you can permit your deposit to take care of itself, so to speak. It may not be a potentially fruitful idea to withdraw funds at the first signs of market fluctuations (when investing in mutual funds) as these may be transient, averaging out and becoming stable over a long duration.
• Consider the Implications of Taxation - Before you invest, consider the effect of taxation on your returns as you don’t want tax liabilities eating into your investment gains. a

Conclusion

Compounding is a powerful way to make your investment work for your long-term needs. Opting for an investment instrument that makes your wealth grow due to compounding gives you a disciplined way of saving your money and putting it to use to fulfil your long-term financial requirements. With the exponential increase of your capital, the power of compounding is potentially best realised if you consider a mutual fund investment, especially a SIP, catering to the needs of small and large investors alike.