As Albert Einstein once famously said, compound interest is the eight wonder of the world. Whether it is a wonder of the world or not, it is surely an amazing concept. If you understand it, you can make it work for you (via investments). If not, if can work against you (via debts). That way, compounding can be a double edged sword.
One of the most well-known investment tactics that many people wish they had implemented (but seldom do) is the “start young” tactic. This investment approach assumes that rates of return are compounded. Yet, often the idea of compounding is assumed to come from income-paying investments – e.g. fixed deposits
On the contrary, compounding can also come in the different shapes & sizes – like profits in mutual funds, equities or other assets.
For example, suppose equity has gained an average of 12% in value every year could be said to have a compounded rate of return of 12%. This is an excellent rate of return, particularly over a long-term investment period.
What is compounding?
Compounding money is a simple concept, yet most of us fail to take its full advantage, partly due to lack of financial discipline.
Suppose you start with $1,000 to invest and over the year, you see a 10% investment on your return. That translates to $100 for a total return of $1,100. If you are taking advantage of the benefits of compounding money you’d then reinvest this entire $1,100. In the next year if you make another 10%, this time you’d make a total of $110, bringing your total to $1,210.
This can, over long run, create an avalanche effect. Because the benefits of early savings in life can be greatly increased by the effect of compounding, starting to save and invest can already make all the difference, so you can enjoy life without worrying about your finances.
If one starts early, hopefully one day one can even live without a salary. Can you imagine working in the future because you want it – NOT because you have to cover your current expenses?
How compounding works in your favour?
Investment is one of the most important ways in which compound interest plays to your advantage. Particularly if you have a large opening balance and a lot of time to grow it, compounding can do wonders for your money. Your money grows because you earn interest not only on your opening balance but also on your accrued interest. You will make interest on your interest, thanks to compound interest.
Investing in a systematic investment plan (SIP) in an equity fund, a public pension fund (PPF) or a national pension plan at an early stage (NPS) can help the investor build up a large investment fund. In investment funds, investing at an early stage of SIP can help help create long-term prosperity. To make compounding work in your favour, one should ideally invest in financial assets that offer a superior return. Yet, be aware of the risks they carry, and be diversified enough that you don’t suffer a permanent loss of capital.
What are key things you should consider while chasing compounding?
- Regular investments – How much you can invest per month? Ideally you should spend what is left after investing and not the other way round.
- Investment time horizon – Enter the number of years your money should grow to help you achieve your financial goals. Time is one of the key success factors in making your investment grow.
- Expected rate of returns? – What is your expected return on investments – For equities it may be more (but with some risk). For fixed returns instruments it can be a bit less (but certain)
Impact of the interest rate on compounding
It is obvious that the higher the interest rate, the higher the return.
Suppose a parent makes an investment of 25 rupees per day, for his child with an interest of 4%. After 25 years the parent could have given his child a gift of only 3.81 lac. If, on the contrary, they invested in an instrument with 8.5%, the proceeds would have been 7.35 lac. While a 12 percent instrument would have given them a higher amount of Rs 12.65 lac.
However, as interest rates rise so does the risk.
Higher-yielding returns are possible typically from riskier instruments like equities. The problem with higher returns is that they are not steady and predictable and often give lumpy returns. Because of this element of unpredictability, it may be difficult to work in the context of short-term planning. There may be some years in which the return is negative, which would be counterproductive for your goals, if they are not long term enough.
Planning financial goals must be cost-effective and predictable. Starting to save early helps us be on course faster. It is more difficult for your savings to meet your needs if you invest later.
To sum it up …
Compounding is a powerful concept. Knowing how it works can help you create wealth and better manage your debt, if any. Once you understand how compounding works can work for and against you, you can take control of your finances and make informed decisions.
An early start gives a head start on the investment process, thanks to that wonderful thing called “time”. It must also be clear that the creation of wealth over time by making effective use of the power of capital, the switch from saving to investing is important. Spend time identifying your goals, link your long-term objectives to your long-term investments, use a mix of debt investment classes and equities for.
Start with investing to achieve each specific goal and let the compounding work its magic.