- Date : 24/12/2016
- Read: 5 mins
How do small amounts invested regularly grow in value over time and help you achieve your financial goals? The answer to this question is compounding.
There is one thing that is common to lucky draws, gambling and poker. A magical stroke of luck miraculously rewards the winner with a huge amount of cash.
While the lottery may not be every man’s destiny, there is one other thing that can make something out of virtually nothing, and that’s Compounding.
The essence of compounding lies in investing a fixed amount regularly over a period of time which then multiplies upon maturity and gives us a much larger amount than we started with.
The key to compounding lies in keeping your money invested for a long period of time and resisting the urge to withdraw it.
To further understand the concept of compounding, let us take the help of an example.
Consider three individuals with similar demographics, Nikita, Sneha and Asavari. They invest the same amount (Rs. 10,000 every month) in the same fund (that offers a return of 8 percent p.a.) which is compounded monthly. The only difference? Nikita starts investing at age 25, while Sneha and Asavari wait till they are 30 and 35, respectively.
|Starts at age||25 years||30 years||35 years|
|No. of months (Retirement age- Start age)||420||360||300|
|Total sum invested||42,00,000||36,00,000||30,00,000|
|Rate of return||8%||8%||8%|
|Fund value at age 60||2,29,38,824||1,49,03,594||95,10,263|
Time is crucial
The key to maximizing financial gains is remaining patient and keeping the invested funds locked away for a long period of time.
When Nikita retires at age 60, she will have a built up corpus of around 2.3 crores (having invested just 42 lakhs). Sneha on the other hand would have around 1.5 crores (having invested 36 lakhs) and Asavari will have only about 95 lakhs (having invested 30 lakhs).
As is evident, while the invested amounts are not very different, the wealth appreciation is sizeable. The difference can be attributed to compounding. It’s because Nikita invested early that she can reap the benefits and secure her and her family’s financial futures.
The reason for this is that the principal amount on which the returns are made increase with time. So for every time period that returns are earned, the next amount earned as a return is a percentage of a larger amount. So for example you invest 1,00,000 every year at a rate of interest of 10%. The return you earn in Year 1 is 10/100*1,00,000= 10,000. In the second year, you earn 10% of 1,10,000 which is 10/100*1,10,000= 11,000. Continuing at this rate, the principal amount would be 2,35,795 by the 10th year, whereas it started at 1,00,000.
It is for this reason you must start investing early. Though there is no benchmarked age for taking the first step towards investment, ideally you should start investing as soon as you start earning. For instance, if you kick starts your career with a salary of 30,000, you must save at least 30 percent of it i.e. 9000 every month and invest it
Money makes money
Rich people around the world have depended not just on their own hard work to make it big- they have made their money work too.
To begin with, we must opt for a PPF in order to witness the magic of compounding. Public Provident Fund is an instrument that requires periodic investments which are then locked away. The relatively small investments made over time grow enormously to provide handsome returns at the end of the lock in period of 15 years.
Fixed Deposits also offer auto- renewal options essentially reinvesting the matured amount for the same term forward simplifying things for you. Over time, the compounding action of FD will work its way to generate a sufficiently large amount of wealth for you.
Bonds also provide a cumulative option wherein the interest earned is reinvested in the same investment. The maturity value will have compounded returns over time.
Now that you understand the nuances of compounding and how to make it work for you, you must always prioritize your future needs over present consumption and leave your money invested to ensure higher long term growth.
Make compounding a significant part of your investment strategy and make your money work hard for you. If you need a push in the right direction, here is a 7 Step Guide to Financial Planning (for dummies).