Top 5 Rules To Follow Seeing the Power of Compounding

Now a days everyone has understand the importance of systematic investment . The main advantage of systematic investment is, you can start with small investments and you will see the effect of compounding and your corpus will grow exponentially. But many of us don't know the Power of this Compounding effect. We will see what is Power of Compounding, what are the rules we should follow to see the full benefits of Power of Compounding in this post.

What is Power of Compounding:


Compounding of Interest or Power of Compounding is computing the interest on the initial amount plus the accumulated interest of previous periods. In simple words, it is earning interest on interest. This is really powerful in accelerating your investments over a long period. Hence this is Power of Compounding. However, to enjoy the benefits of Power of Compounding, you should follow some discipline with your investments. Either it is a SIP in Mutual funds or SEP in selected stocks, the Power of Compounding would yield excellent returns that you cannot imagine with traditional investment approaches.


5 Rules To Follow Seeing the Power of Compounding:


While compound interest is better than simple interest, there are few points you should keep in mind to harness the power of compounding. The following are the rules you should follow to see the full benefits of Power of Compounding.


1. Start Early:

This is the top most rule to follow to see the benefits of Power of Compounding. Start early, so that you will have longer investment horizon, there by your interest earned on interest is more and hence you have time working to your advantage. To illustrate this, assume that Ajay and Vijay both have joined a company at the age of 25 years. Ajay immediately started investing Rs 10,000 every month into a good Mutual fund which earns 10% per annum. Vijay started investing Rs 10,000 every month at the age of 35 years into a Mutual fund which earns 10% per annum. Both have keep on invested into Mutual funds till their retirement (assume that their retirement age is 60 years). Now, we will see the corpuses of Ajay and Vijay.


Ajay will have the corpus : 3.83 Crores


Vijay will have the corpus : 1.33 Crores


There is a huge difference between Ajay and Vijay corpses. This is because, Ajay has started early and he has 35 years to invest which is longer investment horizon and hence the Power of Compounding earned more interest for him.


2. Rate of Interest:

The second most important one is, the Rate of Interest that you earn from your investments. In the above example, we learnt the importance of 'Start Early' with same Rate of Interest for both Ajay and Vijay. Now, assume that both Ajay and Vijay started investing at the same age i.e. at the age of 25 years. However, Ajay investing in a Mutual fund which earns 10% per annum and Vijay investing in a Mutual fund which earns 20% per annum. Now, you know that Ajay would attain the corpus of Rs 3.83 Crores, but what about Vijay's corpus? Yes, every one says it is doubles the Ajay corpus, means Rs 7.66 Crores. But NO, the Vijay's corpus is Rs 63 Crores. It means Vijay's corpus is approximately 14 times more than Ajay's corpus. That is the Power of Compounding with Rate of Interest. Hence, it is always important to choose quality investment which earns more Rate of Interest.


3. Shorter Interval:

The next most important rule is maintaining shorter interval or frequency of Compounding cycle. Compounding can be done Daily, Monthly, Quarterly, Yearly etc. The shorter the interval, the greater the Power of Compounding. Let assume that Ajay invests Rs 10,000 in two asset classes for a period of three years. Asset X gives a return of 7% p.a. compounded annually, while asset Y gives same return of 7% p.a. but is compounded quarterly. At the end of three years, the value of Asset X is Rs 12,250 while that of Asset Y is Rs 12,314. As the frequency of compounding increases, the difference becomes significant. Higher the rate, more you gain Higher the rate of returns, the more you can accumulate. No wonder why experts advise investing in equities if one has a long investment horizon; they offer a better potential rate of return over the long term.


4. Longer Duration:


This shows the discipline of the Investor. A discipline of regular savings for longer duration is very much required to see the Power of Compounding. Longer the time better will be the return. Compounding teaches us that it does not take too much of money to save a decent amount. To illustrate the benefits of longer duration investments and the magic of Compounding, see the following example:

Assume that Ajay wants to invest Rs 5 Lakhs. He splits 5 lakhs into 5 parts and each 1 lakh invested over periods of 5, 10, 15, 25, 30 years. Assuming 10% annual returns, the maturity amounts after the target periods are Rs 1.61 lakhs, Rs 2.59 lakhs, Rs 4.18 lakhs, Rs 6.73 lakhs, Rs 10.83 lakhs, Rs 17.45 lakhs respectively. The compounding effect is clearly visible as the extra amount earned in each of the 5 years is exponentially rising. Gain in the first 5 years is Rs.0.61 lakh while in the next 5 years is Rs.0.98 lakh. This increases to Rs.2.55 lakhs between the 15th and the 20th year and 6.61 lakhs between the 25th and the 30th year. To see the full Power of Compounding, one should start investing early for longer period of time.


5. Do Not Disturb:

To see the real benefits of Power of Compounding, one should not touch their SIP / SEP portfolio. You should not withdraw your money unless you reached your targeted time intervals. However, you can re-shuffle your portfolio once in a year and put the corpus into the new portfolio. If the existing portfolio performing well, then Do Not Disturb this portfolio until next schedule of Re-shuffling.


Points to Remember with Power of Compounding:

  1. To become a good investor, one first need to understand and appreciate how power of compounding can create exponential returns in the long run. A simple concept that all of us learnt in mid school, works wonders when it comes to growth in wealth. Albert Einstein once said: “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”

  2. Suppose, When you save Rs 100 and get an annual interest of 10%, you will have Rs 110 at the end of one year. Due to compounding the next year you will get a 10% interest on Rs 110, which will then leave you with Rs 121. The next year, interest will be calculated on Rs 121 at 10% and so on. In time, these savings will grow exponentially.

  3. There are certain number rules that have been evolved to figure out a quicker method for calculations, especially in finance. Rule 72, is one such quick method of calculating how much time it will take, for your investment to double. So, if you invest Rs 100 with a compounding interest of 10% per annum, the rule of 72 gives 72/10 = 7.2 years as the approximate time frame required for the investment to become Rs 200.

  4. If you equate the same to a larger amount of Rs 1 lakh in approximately 7 years, it would grow to 2 lakh. Remember you will be consistently saving up too, topping up existing funds, hence, if you are planning to retire 60 years from the time of the investment, it will approximately snowball to about 6 times from its original value. This is the avalanche effect of compound interest.

Conclusion:


Compounding is a powerful investment magic. With Power of Compounding, a small amount of money over a longer time can grow into a substantial sum. This is achieved through returns that are earned, but not spent. When the return is reinvested, you earn a return on the return and a return on that return and so on. Therefore it is important to start saving early in order to benefit from the power of compounding returns.

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