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Compounding-Cliched word but the 8th Wonder

Updated: Jun 17, 2021

Compounding money is a simple concept but a very powerful one in it’s impact because of it’s multiplier effect. We’re all familiar with the concept of principal and simple interest on principal.

Assume you invest Rs.1 Lac in a bank which pays out 8% simple interest on the Rs.1 Lac principal amount. So you would earn Rs.8000 interest and another Rs 8000 interest after 1 year after the second year leaving you with Rs.1.16 Lacs after 2 years of investment.

After 10 years you would have received Rs 80000 interest with a total value of Rs1.8 Lacs. After 20 years you would have received Rs 1.6 Lacs interest with a total value of Rs 2.6 Lacs and after 30 years you would have received Rs 2.4 Lacs interest with a total of Rs 3.4 Lacs

Imagine a scenario wherein the bank offers that you don’t take home the Rs.8000 every year and instead keep it with them to earn the same interest of 8% on the Rs 8000 interest retained by them with your permission.

So after the 1st year the amount with the bank will be Rs.1.08 lacs since you have allowed them to retain this interest and hence the interest accrued during the 2nd year will be 8% on Rs.1.08 Lacs which is Rs.8640 thus giving you a total of Rs. 1.1664 Lacs after 2 years , more than the simple interest cumulative amount, due to the compounding element.

After 10 years the money would grow to 100000(1.08)^10 = 2.16 Lacs . After 20 years the money would grow to a nice 4.66 Lacs After 30 years the money would grow to a wow 10.06 Lacs

2 parameters influence the multiplier effect of compounding :

  1. Rate of interest : Higher the rate of interest, higher will be the beneficial impact of compounding

  2. Duration for which invested: It is clear from the above example that the benefit of compounding only increases exponentially as the time for which capital is invested increases since the gains of all the years remain in the investment pool and the rate of return applies to this constantly increasing sub-pool of gains too.

The Investment perspective : From the above explanations it will now be clear why one recommends a longer horizon of investments in Equity Funds. A longer investment not only irons out the volatility associated with equities but allows a higher rate of return to work upon your capital. Adding to that the longer duration further pumps up the compounding benefit , thus giving you a handsome corpus at the end of 7 to 10 years of remaining invested since both parameters contribution to wealth creation are satisfied .

The concept of compounding works wonders even in Debt Funds. Although the rate of return is lower compared to Equity funds, the final corpus after many years of fixed income investing say in a PPF or PF kind of a product can be astounding.

CAGR : This term is often encountered by investors in product sheets of funds suggested by their advisors or distributors. It stands for Compounded annual growth rate and is nothing but a compounded annual rate of return as opposed to an average rate of return. Point to note and pay attention to is that an average rate of return is often a higher number compared to a CAGR value and this often misleads investors to invest in schemes one would have probably avoided had the CAGR number been made known to them.

All the above can be seen within the numbers exemplified here…

Now Let’s assume Equity Mutual Funds with a 12% CAGR in the long term instead of bank deposits explained above. Rs 1 Lac invested today will become 3.1 Lacs after 10 years, 9.64 lacs after 20 years and 29.95 Lacs after 30 years.

We see that we gained 2.1 Lacs in the first 10 years but this gain zoomed to 6.54 Lacs in the next 10 years and even higher gain to 20.31 Lacs in the last 10 years.

The most important lesson from Compounding : Start Early

No wonder Albert Einstein himself referred to Compounding as the 8th wonder of the world.

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