Many of us may have read about the concept of compound interest back in school. However, it is only when we start managing our finances as working adults that we understand the impact and power of compounding. The knowledge of how power of compounding works can not only enable you to earn a higher return on your investments and savings but also help you to plan for your life’s important milestones. The power of compounding can be understood better with the “snowball effect,” wherein you can see how a small ball of snow builds upon itself to form a much bigger snowball as it rolls down a slope. In the same way, the power of compounding too helps increase your savings by accumulating more interest (or capital gains) on the money that was previously earned as interest. In other words, power of compounding leads to what is known as ‘exponential growth,’ wherein both the increasing interest and your account balances at an increasing rate. ...Read More
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Power of compounding is essentially an act of ‘adding interest on interest,’ i.e. the amount of money you invest will generate earnings from both the initial principal amount and the accrued earnings from preceding compounding periods. Eventually, thus, power of compounding helps grow your wealth over time.
There are several investment options in India, offered by leading banks and financial institutions, which credit compound interest on your invested money. Usually, these investment plans have a definitive compounding period, such as annual, monthly, or even daily, helping you leverage the power of compounding as per your needs and requirements.
There are different types of investment, such as fixed deposits and mutual funds, which reinvest the earnings on your money over time, from either interest or capital gains, to help generate additional earnings.
Suppose you invest Rs. 1 lakh every year, in an investment plan that offers a 5% compounding interest annually. At the end of 5 years, your total investment of Rs. 5 lakhs would be worth Rs 5.80 lakhs. If the rate of return increases to 8%, the future value will grow to Rs. 6.34 lakhs. You can use the power of compounding calculator from Max Life Insurance to get a feel of how your returns can vary over different investment periods and rates of interest.
The most exciting aspect of the power of compounding is that your investments accrue interest on both the base capital and the previously earned interest. Overall, the power of compounding helps you build a broad base, which adds on to the previous earnings every cycle.
As an investor, therefore, you must keep in mind that the power of compounding lies in its ability to reinvest earnings on your investment. In other words, you should not look to withdraw your returns, at any point before the investment period culminates.
Otherwise, you would risk limiting the growth potential of your profits through the power of compounding. The choice of the investment plan and period should depend upon your financial goals and your capability to invest. The farther your goal is, the sooner you must start to invest so that you have enough time to accumulate the desired amount of wealth.
Here is an illustration of power of compounding can work on growing your investments over different periods of investments and rates of compounding:
| Year | Opening Balance (Rs) | Investment (Rs) | 10% interest (per annum) | Closing balance (Rs) |
|---|---|---|---|---|
| 1st | - | 1,00,000 | 10,000 | 1,10,000 |
| 2nd | 1,10,000 | 1,00,000 | 33,100 | 2,31,000 |
| 3rd | 2,31,000 | 1,00,000 | 33,100 | 3,64,100 |
| 4th | 3,64,100 | 1,00,000 | 46,410 | 5,10,510 |
| 5th | 5,10,510 | 1,00,000 | 61,051 | 6,71,561 |
As you can see, the total investment made is Rs.5,00,000, whose value increases to Rs 6,71,561 at the end of the 5th year. The difference of Rs.1,71,561 is the total amount of capital gains that you have earned as interest.
On the other hand, if there was no power of compounding, then you would have earned up to Rs.50, 000 as interest (at a 10% rate of interest). Therefore, the difference between the two forms of interests accrued is proof enough of the efficacy of how beneficial the power of compounding is.
As with all good things in life, you must start early with your investments to make the most out of the power of compounding. For example, if you put your money into an investment plan as soon as you start earning, you can enable your savings to grow significantly over time – courtesy the power of compounding.
At the same time, the longer you remain invested without making withdrawals from your returns, you allow your money to grow further because of the power of compounding increases exponentially over time.
With an extended investment horizon, you have time working to your advantage, and your investments have a better chance to accrue more interest. Let's take an example to understand the power of compounding.
Both Ajay and Deepak are of the same age. When Ajay was 25 years old, he invested Rs 50,000 in an investment opportunity, which avails a return rate of 6% p.a. (compounded annually.) By the time Ajay reaches the age of 40 years, the initial investment would grow to Rs 1. 07 lakhs.
On the other hand, Deepak started the investments at the age of 35 years: he too invested the same amount of Rs 50,000 and received the same rate of returns, i.e. 6% p.a. compounded annually. When Deepak turned 40 years old, he would earn Rs. 59.75 thousand only. This is the power of compounding.
Another aspect of the power of compounding is the interval or frequency at which the interest multiplies. Different investment options in India offer a variety of compounding frequencies, such as on a daily, monthly, quarterly, bi-annually or annual basis.
The shorter is the interval of compounding, the more significant impact there is on your investments. For example, let Ramesh invest Rs 10,000 in two different types of investment, for an investment period of three years, while the first investment option offered a return of 7% p.a. compounded annually, the second option offered to provide the same rate of return of 7% per annum but compounded quarterly.
At the culmination of three years, the first investment option was worth Rs 12,250, while the second one was worth Rs 12,314. Therefore, you can see that shorter intervals of reinvestments provide more remarkable returns than more extended intervals.
Overall, when you increase the frequency of reinvesting (or compounding), you can see a more significant difference in your returns. Therefore, it is advisable to invest in equities if you have a long investment horizon – this way, you can avail of a better rate of return over the extended period of investment. You can also use the power of compounding calculator from Max Life Insurance to understand how the power of compounding can increase your returns over different investment periods and rates of interest.
To create a robust and thriving investment portfolio, you must first define your priorities and be disciplined about your investments. Subsequently, you must look to leverage the power of compounding to maximise your investments. Regardless, of how much you are earning, you must devote some time to identify your goals and preference. Doing so will enable us to understand and leverage the benefits of long-term regular investments, and how power of compounding would come into play.
At the same time, you would not be easily enticed into making pre-mature withdrawals to jeopardize your fund’s growth potential. Instead of quick returns, you must focus on giving ample time to your investment so that they can grow into substantial wealth, courtesy power of compounding.
Arguably, you may not have the financial acumen of a seasoned stock investor. However, you mustn’t think that power of compounding is not for you. You may find it difficult to invest in stocks predominantly, as these instruments fall under the volatile asset class and offer no guarantee of returns.
However, the silver lining in stock investments is that equity investments have proven to deliver better inflation-adjusted returns over the long-term, compared to all other investment options and asset classes – thanks to power of compounding. With equity, you can curtail your losses by opting for a stop-loss method. Otherwise, you may risk losing a significant portion of your investment.
In the stop-loss method, you may order the sale of a stock at a specific price, in advance. At the same time, you may diversify your investment across different sectors and market capitalizations to leverage the power of compounding fully.
Investing in Direct Equity and equity mutual funds may enable you to maximize your compounding benefits. However, these investments are also vulnerable to market volatilities. If you are not much inclined towards making high-risk investments, you may look towards other investment opportunities that offer a more secure, fixed power of compounding returns.
First, you have debt funds, which allow you to avail steady returns via fixed interest generating securities such as corporate bonds, treasury bills, government securities, and commercial paper.
Second, you can look into the National Pension System (NPS), An efficient instrument that leverages the power of compounding, NPS is essentially a long-term retirement-focused investment opportunity, which helps you reap compounding benefits through a mix of equity, fixed deposits, liquid funds, corporate bonds, and government fund investments.
Other long-term investment plans that allow you to accumulate wealth through the power of compounding include Bank fixed deposits (FD) and the Senior Citizens' Saving Scheme (SCSS).
Give Your Savings the Power of Compounding!
The benefits of the power of compounding are immense – you can quickly maximize your savings and investments to support your long-term life goals financially. All you have to do is make an early start and be patient with your investments so that you do not hinder their growth potential. Instead, you must remain invested for an extended period to fully leverage the power of compounding. You can reap compounding benefits from a variety of investment options in India including fixed-income and market-linked instruments.
At the same time, you can avail of significant tax benefits with investment under 80C. This way, you can easily augment your savings with a reduced tax liability - making sure that that you stay on track towards a life's worth of disciplined long-term returns, courtesy the power of compounding.
To avail tax benefits and secure your family from any uncertainties, you can opt for Unit linked insurance plans. Unit Linked Insurance Plan (ULIP) can help you in providing a protection cover for family and provide opportunity to invest money market basis your risk appetite.
Overall, you can maximise the effect of power of compounding on your investments while keeping risk at bay and time horizon in mind.
ARN: Sep23/Bg/03M
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