How Does The Power of Compounding Work?

An insight into compounding

30th Aug 2019
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There is a slogan that financial advisors say and every investor should adopt blindly; start early. Starting early leads to stunning results later on due to the power of compounding. Compounding returns, particularly in growth assets such as equity can help investors create wealth provided they give it sufficient time and attention. And thus, they are advised to begin their financial journey early.


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An insight into compounding


Simply speaking, it is the piling of value on top of value. For investments, this means gains made on present gains along with the principal. This theory, when explained with a proper example, would help investors to remember it in an easy way. Like, an investor has put their money in a deposit scheme that offers them fixed interest.


A 6% annual interest on a Rs 1000 deposit will result in Rs 60 payout. In case of simple interest, the investor's account will be credited with Rs 60 per year till the deposit continues. But on the other hand, in case of compound interest, from the 2nd year onwards, the investor will earn a 6% on the last year's interest payout too (along with principal).


Thereby, his 2nd-year interest will be Rs 63.6. Compounding interest tends to increase the return. Now, in the case of a market-linked equity mutual fund where there is an undefined payoff, the investor has decided to go for a share of ABC Ltd, at a price of Rs 1000. The stock gains 12% in a year and thus, his stock price is Rs 1012.


The firm continues to excel and the price charges up 15% next year, 10% the following years and finally, 11% in the 5th year. The return he earned last year will compound with the present year's gains. And thereby, after the end of 5 years, his Rs 1000 will be Rs 1730, i.e a gain of 73%. This exponential growth in investment is always more desirable as compared to the simple return.


Some important things to remember in case of compounding


Compounding works best over a long tenure and this is where the merit of starting early plays a big role. This can be explained better with the help of an example. At 10% per annum, Rs 1000 will compound to Rs 6727 in 20 years. But with a longer investment tenure, it will compound to Rs 17450 in 30 years.


This is why so many people love to indulge in equity mutual fund investments. For the most helpful mutual fund investing advice, one can get in touch with expert advisors. Compounding in equity rarely happens in a straight line. There will be fluctuations in equity returns and thus investors must remain stay invested for a minimum of 7-10 years and witness the potential of equity compounding.


Investors must know how to benefit from the power of compounding and enjoy glorious results. And in this process, they can contact financial experts like Wealthclock Advisors to help them out.


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