By: Tavaga Research
Compounding is probably the most powerful concept in the field of investment and finance. It is easy to comprehend and can be defined as the increase in the value of an investment, due to the interest earned on the principal, as well as on the accumulated interest. The essential process underlying compounding is that the interest earned on the principal is reinvested, so that, the interest that has been added also earns interest.
Power of Compounding Meaning and Example
In other words, if you have INR 1000 and earn 10% in interest, you have INR 1100 at year-end. Then in the next year, if you earn 10% interest on that, you end up with INR 1210 and so on. This demonstrates the multiplier effect that compounding has on the invested money. The power of compounding works by growing your investments at an exponential rate instead of an arithmetic rate (straight line). The steepness of the curve depends on the rate of return on the investment. A higher rate translates to a steeper curve and vice versa.
The foundations of compound interest lie in the concept of the time value of money (TVM), which states that the value of the money is time-dependent. Having INR 1000 today is preferable to receiving it in a year’s time because you can invest it to generate dividends and interest income. The postponement of the receipt of INR 1000 leads to an inflated opportunity cost. Understanding the time value of money (TVM) will help you appreciate the importance of compound interest.
The power of compounding can be calculated from the power of compounding calculator offered by Tavaga.
Factors that determine the compounded accumulation
There are several factors that influence the rate at which the money compounds:
- Interest: The interest rate earned on the investment. A higher interest rate leads to greater accumulation and vice versa. If you invest in stocks, this would be your total profit from both the dividends and the capital gains
- Time Duration: The length of time for which the money is invested. The longer you remain invested; the greater will be the accumulation of the investment
- Frequency of compounding: The third factor that affects the return is the compounding frequency. If the interest is paid bi-annually, quarterly or monthly, then the total amount of interest accrued will be higher than if it is accrued annually. The basic rule for this is that the higher the number of compounding periods, the greater the amount of accumulated interest. The power of compounding in SIP mode is much greater than doing lumpsum investments only
- Starting Principal: How much money are you starting with? The greater the initial principle the greater will be the accumulation and vice versa
- Deposits and withdrawals: The contributions and withdrawals from the principal also have an impact on the return. A greater contribution leads to a greater accumulation. On the other hand, greater withdrawal leads to a smaller accumulation
- Tax: The rate as well as the timing of the tax both impacts the return on the investment. You will end up with far more money if you don’t have to pay taxes
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How does compounding help in wealth accumulation?
Advantages of Compounding
- Greater wealth accumulation: Compounding helps in greater accumulation of wealth as the money grows at an exponential rate. This is the differentiating factor in the final corpus of the accumulation. To illustrate this, consider an investment of INR 1000 at 10%. The table below shows the details:
Power of Compounding Example
Investment Period (In Years) | Accumulation using compound interest | Accumulation using simple interest | Difference |
5 | 1610.51 | 1500 | 110.51 |
10 | 2593.74 | 2000 | 593.74 |
15 | 4177.25 | 2500 | 1677.25 |
20 | 6727.50 | 3000 | 3727.50 |
25 | 10834.71 | 3500 | 7334.71 |
From the above graph, we can clearly see the difference in the accumulated amounts of investment of INR 1000 using simple and compound interest. The divergence increases with the investment period, indicated by the green line above. As evident, at the end of 20 years, the amount invested has grown 6.7 times under the compounding effects as opposed to 3 times under the simple accumulation, highlighting the power of compounding.
- Helps you keep pace with inflation: Inflation erodes the value of money over time. The power of compounding helps you keep pace with inflation.
- Bridges the shortfall in the corpus: With compounding, you can bridge any shortfall in the target corpus. More often than not, you end up achieving the desired corpus.
Enabling the power of compounding
Rules of investment that helps you to get benefitted from the power of compounding
- Starting Early- Longer the horizon, the better: As seen above, you will be able to grow an investment of INR 1000 to nearly 6700 in 20 years, at a compounded rate of 10%. However, extended the investment horizon by another 5 years leads to a corpus worth approximately INR 10800. Therefore the longer the time you have on hand, the lesser you will need to save each month, and the more you can gain from the compounding effects. The longer you invest; the magic of compounding will work in your favor. By beginning early, you will be able to accumulate a much bigger corpus.
- Grow your investment and invest regularly: If you invest a higher amount, the amount of the corpus at the end of the investment horizon will be correspondingly bigger. This is often not taken seriously and people often invest in a haphazard manner. Increasing your investment regularly can make a huge difference over the long run.
The easiest way to understand the effect of compounding on your investment is to use the “Rule of 72”. This rule helps you approximate the rate of return required to double your money in a certain number of years. Alternatively, it can show the number of years required to double your money at a given rate of return.
In other words, the rate of return required to double your money is 72/ Number of years. So, if you are earning say 10% on an investment, you can expect your money to double in 7.2 years. The Rule of 72 is only an approximation, though.
- Learn patience: Investors chasing higher returns forget that it is accompanied by corresponding higher risks, which could result in large losses. As shown above, the power of compounding magnifies over time, therefore it is paramount to have a long-term approach towards investing. Investors should be patient and look out for healthy returns over time.
Online SIP Calculators
Every investor has a different financial goal.
For instance, investor X may want a corpus of INR 1 crore for his retirement after 25 years. Investor Y, on the other hand, may want INR 50 lakhs in 10 years for a house. Online SIP calculators can help you find out how much you need to start investing today in order to attain your financial goals.
The magic of compounding tool, sometimes also referred to as the SIP Calculator helps an investor in calculating total wealth generation over the investment period.
Compound Interest Formula
There are several ways to calculate compound interest. The easiest way is to use an online calculator as mentioned above. Though, it is helpful to see the internal working of the calculations.
Power Of Compounding Formula
The formula is:
A= P(1+[r/n])^nt
- A is the accumulated amount after t years
- P is the principal amount
- r is the annual rate of interest
- n is the frequency of compounding per year
- t is the duration of the investment
Note that the annual interest rate is divided by the number of times it’s compounded in a year. For example, let’s say you put INR 5000 into a savings account paying 5% interest compounded monthly for 10 years. In this situation, you know that P (INR 5000), r (0.05), n (12), and t (10). Pugging these numbers in the compound interest formula gives us: A= 5000(1+ [0.05/12])^120 = 8235.05.
Scenarios when the power of compounding hurts finances
Compounding can also work against you and have negative consequences for your finances if you owe money. The scenarios where compounding works against you are:
- Interest on loans: This is most evident from repayments on your mortgage- for a long time; your monthly payments go mainly to interest and very little towards principal payments. Credit cards often come with high-interest rates. The impact of compounding goes up depending on the frequency of compounding. Credit cards, for example, use daily compounding and this pushes up the effect of compounding. Prioritize paying out high-interest debts first.
- Cost of investments: Investment costs, such as taxes, fees, expense ratio, commission, and other charges, erode your investment returns. These costs reduce the sum of money that is invested. Over the long term, these can have a significant impact on the corpus. For example, a 2% cost paid annually over a 15-year period can reduce the final corpus by as much as 12%.
- Inflation: Inflation is another way compounding eats into your wealth. This reduces the value of the accumulation each year by the rate of inflation. For example, a 5% inflation means that you would have to pay 107% more for the same expense in 15 years.
The effect of compounding can be more significant if your money has abundant time to work for you. Along with a longer time horizon, periodic investing at various intervals helps the principal to grow multifold.