Compounding or compound interest plays an important role in the investment of an individual investor.
According to FI (Funds Instructor), it means investors have not only received an interest in the basic principal amount that they have invested but also on the interest that keeps getting added to it.
In other words that compounding refers to the reinvestment of your savings at the same rate of return to constantly grow the principal amount every year.
It is the most powerful tool or technique that you can use to plan for their future goal such as retirement, children’s education, children’s marriage, and health-related issues, etc. All you need to do start investing early and over time, and then compound interest will be helps to increase your investment.
Benjamin Franklin once wrote somewhere that ”It is the stone that will turn all your lead into gold. Remember that money is of a prolific, generating nature. Money can beget money, and its offspring can beget more.”
For example, if you start your investment with ₹ 200 with 9% interest per annum, then your principal amount is ₹ 200 and the earnings, at the end of the year, are ₹ 18 (9% of ₹ 200). However, instead of spending it, if you choose to reinvest it, then your principal amount for the next year becomes ₹ 218 (₹ 200 + ₹ 18 interest) and the earnings you get are ₹ 19.62 (9% of ₹ 218), which are ₹ 1.62 more compared to the first year.
Even though this looks like a small amount, but it can make a huge difference to your investments, if you let your investment for a long year.
Therefore, the longer you stay invested the more money you will make. The best way to take benefit of compounding is to start saving and investing wisely as early as possible. The earlier you start investing, the greater will be the power of compounding.
The key role of investment that enables compounding
- Early start: Starting early to invest is the key to making the most out of the power of compounding. If you start your investing from the time you start earning, then it will enable your funds to grow further over time.
- Regular investment: If you wish to create a smooth and healthy portfolio, then you must be regular in your investments.
- Patience: Some investors would like to have quick returns, they do not realize that it is the long-term investments and they will have to give your investment some time to grow to a significant sum.
- Investment habit: Every individual should inculcate the habit of saving in their life cycle. And investors should also need to know where they need to spend their money. If you spend wisely now, then you will save some money and spend that amount on investment to build a better future that will help you fight your future uncertainties.
Example: if you investing ₹ 1 lakh a year and increase your investment by 10% a year, then this is how compounded interest helps your money grow.
If there were no compound interest, then your total investment of ₹ 5 lakh would have earned you ₹ 50,000 at 10% interest. The difference made by compounding is worth ₹ 1,71,561 in the above example. That’s almost 3.43 times more than what you have earned with compounded interest.