Compounding is the mantra of wealth creation which is missed by many due to restless human behavior. In purely mathematical terms, 'compounding is defined as ‘the increase in the value of an investment, due to the interest earned on the principal, as well as the accumulated interest.’ Compounding is a very powerful tried and tested tool for wealth creation in the long term. You can build wealth for your retirement and other big goals using this compounding rule.
What is the power of compounding?
Simple interest means you earn interest on your principal. But with compound interest, you earn interest on the principal amount as well as the accumulated interest amount over successive periods. Over time, this interest accumulates into a big amount and you get even bigger returns and so on. Compounding takes place when the return on the principal in the first period is added back to the principal in order to calculate the interest for the following periods.
The more frequently your money earns interest, the faster and bigger your balance will grow. As interest is added to your account, you earn interest on the original balance, plus the previously earned interest. One of the biggest benefits that investors can appreciate about the power of compounding is the value of time. With time, you will gain returns, and the yields on these returns could further generate returns which results in a big capital.
When you regularly invest over time, your returns could accumulate at a much faster pace.
Imagine 'A' and 'B' have invested Rs. 10,000 each for 20 years. 'A' has invested in a financial instrument that is giving yearly compounding return of 10% and 'B' is just getting a simple yearly return of 10%. Now let’s see the difference:
Because of compound interest, in the case of 'A', the interest that A earned in the previous period was included in interest computation for the next period. In the case of 'B', for every period, interest was calculated on the initial principal only. Because of the power of compounding, ‘A’ the wiser became richer than 'B'.
Here I am putting a compounding interest calculator; use this to calculate your scenario:
Key rules to enable the power of compounding
Many people wrongly assume they can begin investing only when they have large sums of money. Therefore they delay investing until they are in their mid-forties. This is not a good investment strategy. On the other hand, when you start investing from an early stage, it doesn’t matter how much you can invest you can start with 1000 or even from 500. There are many mutual funds where you can start putting small sums of money at an early age and you will be surprised later with the returns.
You have to just follow these 3 points:
Time – Invest as early as possible. Don’t think that you are too young and even you are a student, you can start with your pocket money. You have not to ignore the benefit of early starters.
Stay Invested – Do not withdraw money unless it is an emergency and there are no other means for funding. To create a healthy corpus and meet your financial goals on time, it is critical to have investment discipline. Investing regularly at the start of your investment journey can ensure discipline. It is wise not to skip your SIP payments.
Grow The Investment – No matter how tiny the amount is, incremental investments do wonder to the wealth-building process.
As we have seen, the power of compounding magnifies over time. Hence, it can help to have a long-term approach towards investing. One must invest patiently that could reap healthy returns over time.
You don’t need to be a financial expert to benefit from the power of compounding. Every investor can take advantage of this concept and put it to good use. So, start investing today to enjoy a great future.
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