Power of Compounding - Meaning, Calculation, And Benefits
Would you rather want Rs 1 crore today or just Rs 1 doubled every day for 30 days? I’m sure you’d choose Rs 1 crore! But have you ever wondered what would be the worth of Rs 1 doubled every day for 30 days?
| Day | Amount | Day | Amount | Day | Amount |
| 1 | ₹1 | 11 | ₹1,024 | 21 | ₹1,048,576 |
| 2 | ₹2 | 12 | ₹2,048 | 22 | ₹2,097,152 |
| 3 | ₹4 | 13 | ₹4,096 | 23 | ₹4,194,304 |
| 4 | ₹8 | 14 | ₹8,192 | 24 | ₹8,388,608 |
| 5 | ₹16 | 15 | ₹16,384 | 25 | ₹16,777,216 |
| 6 | ₹32 | 16 | ₹32,768 | 26 | ₹33,554,432 |
| 7 | ₹64 | 17 | ₹65,536 | 27 | ₹67,108,864 |
| 8 | ₹128 | 18 | ₹131,072 | 28 | ₹134,217,728 |
| 9 | ₹256 | 19 | ₹262,144 | 29 | ₹268,435,456 |
| 10 | ₹512 | 20 | ₹524,288 | 30 | ₹536,870,912 |
According to the table, you can see that the value of just ₹1 doubled every other day for 30 days would be more than 53 crore! This is 53 times more than the ₹1 crore you would’ve received on day 1! This is the power of compounding. Over the long term, small investments can snowball into huge sums, rendering great benefits.
What is compounding?
“Compound interest is the 8th wonder of the world. He who understands it, earns it, he who doesn’t pays it.” - Albert Einstein
Compound interest is the process where the returns earned on an initial investment are reinvested, leading to growth not only in the original amount but also in the accumulated returns. It refers to the interest that is earned on interest as well as on the principal invested amount. Unlike simple interest, where you earn interest only on the principal amount, compound interest accelerates growth as the interest itself starts generating returns.
How compounding works?
Compounding works by reinvesting the returns earned on an initial investment, allowing your money to grow exponentially over time. When you invest a principal amount, it earns returns (such as interest or profits). These returns are added back to the original investment, creating a new, larger base for calculating future returns. As this process repeats, you start earning returns not only on your initial principal but also on the accumulated returns, leading to faster growth over time.
Compound interest formula
Compound interest can be calculated using the following formula -
Compound Interest = (P*[(1+R)^N]) - P
Where P =Principal amount (Investment amount)
R = Rate of compounding
N = Total periods of compounding (Years/months)
Let’s look at the calculation with the help of an example,
Assume that the principal invested amount (P) is Rs 50,000, the rate of return (compounding rate R) is 12%, and the period of investment is 20 years. In this scenario, the return can be calculated with the following formula -
P*[(1+R)^20]
= 50,000*[(1+0.12)^20]
= 50,000*[(1.12)^20]
= 50,000*9.65
= 4,82,314.65
Hence, this shows that the value of an investment of Rs 50,000 and 12% interest will be Rs 4,82,314.65 in 20 years. To calculate the compound interest portion, we can subtract the principal amount from the corpus built. Thus, compound interest is Rs 4,32,314.65 (4,82,314.65 - 50,000).
When contributions are at regular intervals, like through an SIP in mutual funds, you can calculate the returns using an SIP calculator.
The Compounding Curve
The formula of compound interest creates an exponential equation. Hence, when you look at it in mathematical terms and plot it on the xy-plane, you can see an upward curve. An example of this is shown below -
The above chart shows the growth of an investment of Rs 1,00,000 at a rate of 12%, corresponding to the number of years. This indicates that the higher the number of years, the higher your corpus will be accumulated. Moreover, it also indicates that in the early years, the growth may be slow, but when enough time is given, the growth rate is exponential.
Factors affecting compounding
- Principal Amount (P): The initial amount of money that is invested, or the principal amount, affects the calculation of compound return. The principal amount is directly proportional to compound returns. A higher principal results in more interest earned over time.
- Interest Rate (R): The interest rate or the percentage at which interest is calculated also impacts the way compound returns are calculated. A higher interest rate increases the amount of interest accrued.
- Compounding Frequency: The number of times the money is compounding and added to the principal within a given time period. For instance, in some cases, the interest on an investment may be compounded more frequently, e.g. semi-annually, quarterly, monthly, or daily. More frequent compounding results in more interest accrued. To account for the impact of compounding frequency, it has to be converted into yearly interest and then multiplied with the number of years. For instance, if an investment pays out 12% compounding monthly (1% every month), for 20 years, time (N) will be 1*12*20 = 240.
- Time (N): The longer the duration for which the money is invested, the more interest is earned due to the compounding effect since time and compound returns are directly related.
- Additional Contributions: Any additional investments made during the investment period can increase the total amount of interest earned. This is because each investment will generate new compounding periods, increasing the overall return. E.g. SIP in mutual funds.
- Inflation: While inflation does not directly affect the calculation of compound interest, inflation can impact the real value of the returns on investment. When inflation is accounted for, investors can gain a real picture of the returns that they have generated. The real rate of return nets off the impact of inflation and taxes. Hence, it should be considered before making investment decisions.
Simple interest vs Compound interest
Let’s look at the differences between simple and compound interest and where they are used.
| Difference Parameter | Simple Interest | Compound Interest |
| Calculation | Interest is only calculated on the principal amount | Interest is calculated on both, the principal amount and the interests generated |
| Formula | (P*R*N) | (P*[(1+R)^n]) - P |
| Type and graphical presentation | Linear growth. Please refer to the chart below for a comparison | Exponential growth. Please refer to the chart below for a comparison |
| Returns | Returns are lower | Returns are higher |
Hence, based on the above differences, instruments that offer compound interest can give you an edge in your wealth-building journey to grow faster. Investors should ensure that they choose investment avenues that provide compound interest rather than simple interest.
Benefits of compounding
- Exponential growth - One of the biggest advantages of compounding is exponential growth, where investment returns increase at an accelerating rate over time. This happens because interest or returns earned in one period are added to the principal, and in the next period, interest is calculated on this new, larger amount. Unlike linear growth (where returns increase at a constant rate), exponential growth means that the longer you stay invested, the faster your money grows.
- Key to need fulfilment - The power of compounding is essential for fulfilling financial needs, as it enables individuals to accumulate wealth over time. By investing early and regularly, compounding allows for substantial growth, making it easier to fulfil long-term needs like retirement, education, or purchasing a home. This financial growth not only provides security and stability but also helps maintain purchasing power against inflation.
Power of compounding and SIP
While many investments provide the benefit of compounding, it stands out as a benefit of systematic investment plans (SIPs). Through SIPs, regular contributions are made at periodic intervals. This also creates discipline among investors. Each investment made via an SIP would trigger a new compounding cycle, making each investment take advantage of the benefit of compounding on returns. Moreover, the benefit of rupee-cost averaging coupled with compounding can significantly reduce the cost of investment purchase and the consequent tradeoff of compounding returns.
4 Mistakes to avoid when investing in instruments that provide compounded returns
- Delaying investment - Time given to the investment and returns derived from it are directly related to one another. Hence, the higher the period of investment, the greater will be the return. Delaying investments can result in missing out on the benefits of compounding over time. Starting early allows for more time for your money to grow. The more time you give to your investment, the more it can benefit from the power of compounding.
- Redeeming investment prematurely - Taking out funds from an investment can hinder growth. The longer you keep the money invested, the more you benefit from compounding. This is because compound interest works best over time, allowing your returns to generate further returns. With each passing year, the accumulated interest is added to the principal, leading to exponential growth. Frequent withdrawals interrupt this cycle, reducing the potential gains. Staying invested not only maximises wealth building but also helps in overcoming market fluctuations, ensuring that you reap the full benefits of long-term compounding.
- Timing the market - The stock market is extremely volatile, changing at a fast pace, literally every second. One can’t predict the market movements, and when one tries to do so, one might end up delaying investment in a bid to wait for the ‘perfect time’ that may never arrive. Consequently, due to this, they may miss out on benefitting from a longer compounding period. Hence, rather than timing the market, investors should focus on time in the market, which will allow them to gain the maximum benefit from compounding.
- Chasing short-term gains - Sometimes, investors focus on short-term gains, and hence indulge in risky investment avenues such as options and futures or indulge in short-term trading. In such a scenario, investors may end up making losses and miss out on the opportunity to leverage the power of compounding in their long-term wealth-building journey.
Conclusion
The power of compounding should not just be seen as a mathematical equation; rather, it is a crucial principle for long-term wealth accumulation. By staying invested, making regular contributions, and allowing time to do its magic, investors can unlock exponential growth and financial security. The key lies in consistency and patience, rather than chasing short-term gains or trying to time the market. Whether through SIPs or lump sum investments, compounding rewards those who trust the process. Ultimately, the earlier one starts and the longer one stays invested, the greater the potential for financial independence and wealth accumulation.
Mutual fund investments are subject to market risks, read all scheme-related documents carefully before investing.