Power of compounding: How does compounding work in stocks and mutual funds? Optimise benefits of compounding

Compound interest increases the value of your investment faster than simple interest

What is compounding How to benefit from compounding in stocks and mutual funds

Apparently, Albert Einstein could never quite understand compound interest. He called it “the eighth wonder of the world” and summed it up thus: “He who understands it, earns it; he who doesn’t, pays it.”

So, if you want to go one up on one of the most celebrated Nobel Laureates of all time, here’s your chance: sink your teeth into compound interest – and in the bargain, learn how to earn from it too.

What is compounding?

Compounding is a process where the interest earned on an investment is reinvested along with the original investment, making the interest become part of the principal. This way, the initial invested capital keeps getting bigger, and the process of earning continues – on an invested capital that is swelling.

So, essentially, compounding is the process of earning interest on interest, leading to what is called the “miracle of compounding”. This makes it different from simple interest, which is paid only on the principal. This is also why compound interest increases the value of your investment faster than simple interest.

However, it can also prove to be downside in case you borrow under the compounding principle; your debt burden increases as the interest accumulates on the unpaid principal and previous interest charges, just as your earnings would if you had invested.

Compounding periods can be annual, monthly, or even daily, as is done with your savings bank accounts, where the interest is calculated as compound interest.

How does compounding work?

To understand how compound interest works, let us assume you have invested Rs 10,000 in a scheme that offers an annual interest pay-out of 5%.

After the first compounding period (i.e. the first year), your total amount in the savings account would rise to Rs 10,500. That is, 5% of Rs 10,000 works out to Rs 500 by way of interest and is added to the principal. Compound interest comes into play only from the second year.

After the second compounding year, it is this enhanced principal of Rs 10,500 that sees a growth of 5%, which works out to an overall gain of Rs 525. This takes your balance to Rs 11,025. Here, both the principal and the first year’s interest earnings have seen growth – of Rs 500 and Rs 25 respectively.

You may think, you ‘only’ earned Rs 25 more in the second year as compared to the first, but that would be wrong. If this was calculated in terms of simple interest, the additional accrual would have been zero – i.e. you would have earned interest of a flat Rs 500, the same as in the first year, and not Rs 525 as it is now – with compounding.

Also, with compound interest, the longer the time period given to an invested amount, the more is the potential to accelerate returns on that investment. So, after the third year, your balance would read Rs 11,576.25. In other words, the Rs 25 gain has now increased to Rs 51.25.

If you do not make any withdrawals in the next 10 years, and assuming that the interest rate stays a steady at 5%, your original principal would grow to Rs 16,288.95.

How does compounding work in the stock market?

There is actually no compounding in stocks on the lines of a normal bank deposit, where the interest rate is predetermined, though the principle of compounding is applicable for shares and companies. Mutual funds are, however, designed in a way to extract the maximum from compounding. Let us consider them first.

Compounding in mutual funds

Mutual funds exploit the idea of compounding by adopting the growth option, where the fund manager reinvests the profits earned in the underlying scheme. This helps to generate greater returns than one would expect from the fund’s dividend option.

Also, with a mutual fund, if you increase your investment by degrees each successive year, compound interest will be calculated on the new investment along with the existing investment and the returns on it. 

Let us assume you have decided on a five-year exposure to a fund, starting with an investment of Rs 1 lakh in the first year, and increasing it by 10% every year thereon. At the end of five years, compounded interest will help your closing balance cross Rs 8 lakh.

This is how your earning will read at 10% compound interest per year, albeit on slightly inflated investment with each passing year:

  • At the end of Year 1: Rs 10,000
  • At the end of Year 2: Rs 22,000
  • At the end of Year 3: Rs 36,300
  • At the end of Year 4: Rs 53,240
  • At the end of Year 5: Rs 73,205

You would have invested a total of Rs 610,510 – factoring in a 10% increase in the investment every year – and reaching a five-year closing balance of Rs 805,255.

Your gain becomes clear when compared to simple interest earnings. The total interest you will have earned here, from compounding, is Rs 194,745, or nearly Rs 1.95 lakh; if this were simple interest, your interest earning (on the same increased investment every year) would have been only Rs 1.5 lakh. 

Compounding in stocks

With stocks, compounding is trickier – and less cut-and-dried compared to predetermined returns from a bank deposit. There is no rising value of returns per se. It is the value of the stock you hold that gets compounded. 

Let us elaborate on this further. Go back to our first example, and imagine you have invested Rs 10,000 in Company A. The first year sees your shares rise 5% to Rs 10,500. Once again, compounding will become apparent only from the second year.

Let us assume your shares appreciate another 5% in the second year; this means your holdings are now worth Rs 11,025 – because the Rs 500 you gained in the first year also appreciated 5%. But do bear in mind that the reverse is true as well; you can lose exponentially if your holdings lose value.

How to optimise the benefits of compounding

To get the maximum out of compounding, it is advisable to fall back on the three golden rules of investing:

  • First of all, start early
  • Second, set your goals and be disciplined 
  • All along, remember to hold your patience

Let us consider the first rule first; starting to invest the moment you are assured of a regular income gives you that much more time to grow your wealth. A fresher at age 25 will have a head start on someone who begins investing at 35. And if that doesn’t convince you, remember that Warren Buffett began investing when he was just 11 years old.

It helps if you have goals in mind. This keeps you on track and helps you to be regular with your investments. Disciplined investing is called for, which means regardless of how little your income is, yo u must learn to keep some money aside for investing.

Finally, forget about getting rich overnight from investing. It is long-term investments that benefit from compounding, which means you need to be patient and let your investment grow at its own pace.

Last words

The last point leads us to a key rule of investing in any instrument: as an investor, you must have a basic knowledge of how your returns accrue from whatever you are investing in. With compounding, it involves realising that you need to have a long-time horizon. And for that, it helps if you start at the earliest.

Also, remember that you can lose money rapidly if you invest in shares that lose value instead of gaining. This is why it is all the more necessary to study the fundamentals of the company you are investing in. External factors leading to downturns are temporary – a global health scare will soon pass, a geopolitical friction somewhere in the world will blow over – but the fundamentals of the company remain the same. This is where you must be on your guard. 

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