The magic of compounding

In life, there is no such thing as a free lunch. This means that you always have to make an effort or pay money to get something good. This is largely true for investing as well. You must make an effort to invest correctly and curb your behavioural biases to stick to your investments. However, if there is anything that comes close to being a ‘free lunch’, it is the power of compounding.

The magic of compounding

Compounding is a mathematical process that can multiply your potential earnings from an investment. The compounding process ensures that you earn interest on your original invested amount and also earn interest on the returns. Let’s understand this better with an example. Assume you invested Rs. 5000 at an interest of 10%.

• In the first year, you will earn an interest of Rs. 500 (10% of 5000).
• In the second year, you will earn 10% on the original invested amount, i.e., 10% of Rs. 5000 and 10% on the interest earned in the previous year, i.e., 10% of Rs. 500. Thus, total interest earned in the second year would be Rs. 550.
• In the third year you will again earn 10% of Rs. 5000, i.e., Rs. 500 and 10% of the interest earned so far, i.e., 10% (500+550) = 105. Thus, the total interest earned in year three would be Rs. 500 + Rs. 105 = Rs. 605.

This process is continuous in nature. This is why it is said that the maximum benefit of compounding can be reaped over the long-term.

Make the maximum of compounding

Compounding is a great way to grow your wealth. However, there are few things that you can do to gain the maximum from the compounding process.

• Start early: Ideally, you should start investing as soon as you start your earnings journey. However, even if you have not started that early, now is a good time to start. The compounding process works best if you start early and stay invested for the long-term. The power of starting early is such that even if you invest more money later or generate slightly higher returns, you will still not be able to catch up with an investment made earlier. This missed opportunity is called the cost of delay and it can have a big impact on your compounded returns.

Cost of delay when you start investing 5 years later

When you delay your investments, even an increase in the rate of return cannot help you make up for the lost returns

When you delay your investments, even an increase in the amount invested cannot help you make up for the lost returns

• Be disciplined: If you really want to benefit from the power of compounding and grow your wealth so that you can achieve your financial goals then you must be disciplined about your investments. This means that you must start your investment journey and make sure that you invest regularly. As we have seen from the above examples, even a small delay or gap in investments can have a big impact on your ability to benefit from the power of compounding.
• Be patient: Just like Rome was not built in a day; your wealth creation journey will also not happen overnight. You must understand that it will take you time to create a corpus that can help you achieve all your financial goals. Patience is the key here. Many times, you might get influenced by your own personal biases or changes in the market environment and stop making regular investments. This can be detrimental to your goals. Thus, it is important for you to be patient and stay invested for the long-term in order to benefit from the power of compounding and potentially generate the desired returns.

Power of compounding and mutual funds

We already know that compounding is a great way to potentially create a sizable investment corpus. However, wouldn’t it be great if you could not only benefit from the power of compounding but also automate the compounding process?

This can easily be achieved by investing in mutual funds via the Systematic Investment Plan (SIP) route. When you invest in mutual funds via an SIP, you make fixed investments into a mutual fund scheme of your choice at regular intervals. This ensures discipline. Since you can choose the investment interval, i.e., fortnightly, monthly, or even quarterly, this route of investing becomes simple and convenient. More importantly, an SIP investment can be started with as low as Rs. 500. This means that you can start investing in mutual funds through SIP as soon as you start earning. As your disposable income increases you can increase your SIP investments. However, if you do not have a large amount of disposable income, you can still start your investment journey as early as possible with an SIP. This way, an SIP can help you start investing early, stay disciplined, and invested for the long-term.

So, as an investor, all you need to do is start early and continue investing to reap the maximum benefits of compounding. With an SIP, this becomes even easier.

Tables provided in the article are for illustration purpose.

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