The Power of Compounding

The Power of Compounding

by Anand Kumbhare

Any amount invested in market instruments which fetch yield more than the rate of inflation is termed as an “Investment” whilst the yield which is less than the rate of inflation is termed as “Savings”.

Well, Savings is considered mostly for protection against untoward circumstances especially when someone wants security but Investment from a financial perspective is definitely a wealth creation tool.

Disciplined habit with invest-first and spend-later is the key to success for financial freedom. Many Investment instruments present in the market provides yearly returns based on simple interest but there exist many other that fetch the returns purely based on compounding principle.

Compound Interest (CI), as Einstein has rightly said is the 8th wonder of the world, “He, who understands it, earns it”, accordingly to him.

Compounding is the ability of an asset to generate earnings from previous earnings as time passes. Unlike linear growth through “Simple Interest” where only the principal earns interest each period, Compounding is exponential based growth where two principles work simultaneously. One is the return rate and the other is the savings that accumulates which gets added as the principal for the next period. And this accumulated wealth is a direct realization of the time value of money, known as “Compound Interest”.

Compound Interest (CI) formula may be depicted as below

A = P ( 1 + r)^ n

Where

A = Amount

P = Principal Invested

r = return (considered for compounding)

n = Number of times returns is compounded

So unlike Simple Interest (SI) where interest is depicted as “i”, Compound Interest depicts the interest as “r” termed as returns.

The reason it is “r” and not “i” is because in subsequent periods this return component “r” increases in leaps and bounds as in continuous growth as compared to linear growth with “i” as simple interest.

Continuous Growth

Example:

Let’s calculate Amount A, with compound Interest for the Principal Invested, P = Rs. 1,00,000 and “r = 13%” compounded annually for the varying periods that reflect the power of compounding.

table 1bb

The above example depicts the amount A with the power of compounding with r, the rate of returns compounded annually over the different periods. One can conclude that benefits of the compounding increases in later years and therefore it does make sense to invest for longer terms to reap the rewards associated with the compounding effect.

In practical scenarios, one may have the rate of return with a different compounding frequency. It can be daily, weekly, monthly, quarterly, half-yearly etc.

Compounding Frequency

The important fact to note is that the effective rate of return is much more when the compounding frequency is periodic than one could expect as compared to annual compounding i.e, the rate at which compound interest accrues depends on the frequency of compounding.

In other words, the higher the number of compounding periods, the greater is the effect of compound interest.

Now, let us consider the following illustration with r= “0.25%” COMPOUNDED WEEKLY for the same periods as considered in the above example and observe the power of compounding for a fixed Principal of Rs.1,00,000.

Compounding frequency: Weekly, r=0.25%, P=Rs. 1,00,000

table 2cc

Now, consider the following illustration with r=”x%” with compounding frequency weekly for the same periods as considered in the above example.

Let’s compare and evaluate these individual pieces

table 4cc

What can be concluded from the above is that one needs to be little disciplined to wisely invest into instruments quite early, periodically and repeatedly. In the long run, it definitely gives a higher returns than the inflation.

Good investment does the following right things:
1. Start early in life
2. Start with lumpsum amount
3. Benefit from regular compounding
4. Keep target for long-term (3/5/10 years)
5. Ensure discipline in adding more at regular intervals

Well, if you want to know how it can be achieved, write us to know more details.
We will share our expertise to do so.

** All investments in securities are subject to market risks and the NAV of the Scheme can go up or down depending on the factors and forces affecting the securities markets. There can be no assurance or guarantee that the objectives of the Scheme will be achieved.

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