What is the Power of Compounding?

If you have previously invested or looked up investment guides, chances are you have come across the term 'compounding' or 'the power of compounding’. But what does this mean for you as an investor? Compounding is the magic of investing, and it can be the single factor that turns your small amount into a large one.

This article will answer everything you need to know about the power of compounding in investments.

Compounding is simply a process of 'building interest on interest,' which means that the amount of cash you invest generates returns from both the original principal amount as well as the collected earnings from previous compounding phases. Thus, the force of compounding ultimately aids in the growth of your assets over time.

In India, leading banks and financial organisations provide a variety of investment alternatives that generate compound interest on the invested funds. These investment schemes often include a defined compounding period, like annual, monthly, or perhaps even daily, allowing you to use the potential of compounding interest as per your desire.

There are multiple investment schemes which help you accumulate a good amount of wealth over time by letting you reinvest your generated returns in order to get the compounding effect ongoing.

Here is an example which will help you understand how the process of compounding takes place:

Let’s say, you annually invest INR 1 lakhs in an investment plan which offers you a 5% interest every year. So, at the end of the first year, you will get INR 5,000 in interest. Now, when the second year starts, your opening balance shall be INR 1.05 lakhs instead of INR 1 lakhs. This is because the interest generated in the first year will be added to the opening balance of the second year. What this does is, increases the interest income from INR 10,000 to INR 10,250 in the second year. Now, this cycle continues. Each year the interest earned is added to the opening balance of the following year. This helps you generate and accumulate interest amounts much more quicker.

Here is a table showing the power of compounding in a 5-year time period.

Here are some tips to help you make the maximum out of the power of compounding:

• Start early:

  To take advantage of the immense power of compounding in your investments, you must begin your investments as soon as possible, as with all of life's good things. For instance, if you invest your cash into an investment plan as you begin earning, the magic of compounding interest will allow your savings to increase dramatically over time.
  
  Simultaneously, the longer you stay engaged without withdrawing your profits, the more your money grows since the force of compounding grows tremendously over time. Having a longer investment horizon works in your favour, and your assets stand a higher chance of earning more money.



• Set short compounding intervals:

  The period or rate at which the investment interest multiplies is yet another facet of the capacity of compounding. Different investing alternatives in India include a range of compounding intervals, including daily, quarterly, monthly, semi-annually, and yearly. The shorter this compounding period, the greater the effect on your assets.
  
  You can observe a more substantial improvement in your earnings if you raise the rate of re-investing (or the frequency of compounding). As a result, if you have a lengthy investing outlook, it is best to invest in stocks to benefit from a higher rate of return across a longer period of time.



• Disciplined Investment is the key:

  To build a strong and healthy investment strategy, you must first determine your goals and invest with consistency. As a result, you must wish to enhance your investments by leveraging the power of compounding. Irrespective of your income, you must spend some time identifying your objectives and preferences. This will allow you to comprehend and exploit the advantages of long-term consistent investments, as well as the magic of compounding interest. In the meantime, you would be reluctant to make premature withdrawals that would harm your fund's development capacity.



• Choose wisely:

  You might not have the financial insight that an experienced stock investor possesses. However, you should not dismiss the power of compounding. You might find it challenging to invest primarily in equities because these assets are unpredictable and offer no assurance of profits.
  
  The positive aspect of equity investments is that, because of this same power of compounding, equity investments have been shown to produce superior inflation-adjusted returns in the long run than most other investment alternatives and types of assets.¹



• Fixed return schemes:

  Participating in Direct Equity or equity mutual funds can allow you to maximise the benefits of compounding. Such investment routes, however, are exposed to market volatility. If you're not interested in high-risk investment routes, you may want to consider other investment possibilities that provide a more solid, guaranteed³ power of compounding earnings.

In the end, all you need to do is make sure that your money works for you and that it can cover your future expenses. Compounding is one of the most fascinating and important concepts in finance. It is the factor that helps your money grow exponentially over time. However, the power of compounding doesn't work overnight. It is slow and steady, but it is also the most powerful force in the universe of investments. As an investor, it is imperative that you take advantage of this force for all it is worth.

As long as whatever method you choose has the potential to increase its value over time, then you can let time do the rest of the work. So, what are you waiting for? It's time to start using your hard-earned money towards investing.