What is Power of Compounding?
Compounding refers to the reinvestment of earnings at the same rate of return to constantly grow the principal amount, year after year. It is a technique of making your money work harder for you and is perhaps the most powerful tool that an average investor can use to plan for many of life’s financial goals, including retirement.
Compounding is the magic of investing said Jim Rogers, the famous American businessman and financial commentator. It is indeed one of the most powerful weapons in an investor's arsenal. The beauty of this concept lies in the fact that it is quite simple to understand. But when you put it into practice, the impact can be immense.
Mathematically speaking, 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.
It is a strategy that makes your money work for you. It could be regarded as a powerful tool to grow your wealth. Simple interest means you earn interest on your principal. But with compound interest or compunding as its popularly known , you earn interest on the principal amount as well as the accumulated interest amount over successive periods. Over time, this interest snowballs into a substantial amount. Money begets money, and its offspring begets more.
Now, you might be thinking what’s so great about the power of compounding. Even a school going kid knows the term. Yes, you might argue that. However, there are things that the school going kid doesn’t know and if he understands it, he can set the whole world on fire.
Let’s see how the concept of compounding works. A and B are two friends who have just started their career at the age of 20 & 40 respectively and supposed to retire at 60. Suppose A invested Rs 1,00,000 at the age of 20 and locks all his investments till retirement. While B, however, doesn’t make any investment till he is 40. At 40, he invested Rs 1,00,000 and locks it till the age of 60. Assuming that the growth rate (interest rate) is 15 percent per annum.
On retirement, at the age of 60 A will get over Rs 2.6 Crores while B will only get Rs 16 lakhs. Therefore, over 16 Times Growth in the Investment for A compared to B. That’s the power of compounding!
Compounding is a simple, but very powerful concept. Why powerful? Because compounding is similar to a multiplier effect since the interest that is earned by the initial capital also earns an interest, the value of the investment grows at an exponential rate rather than an arithmetic linear rate. The higher the rate of return, the steeper the curve.
Hope you understand this concept and the next time you plan to borrow money on credit cards, remember that compounding is working against you.
