There is a famous quote from Mr. Warren Buffett, and it says that if your money is not growing while you are sleeping, then you will have to work until you die. So what does this mean, and how can you grow your money even while doing nothing? The answer is by harnessing the power of compounding. This is one of the basic principles and learnings in an investment journey. Let us break down the concept of compounding in detail here for better understanding and to eventually reap better returns from investments.
Compounding is the process where your money earns returns, and then those returns also start earning more returns over time. Think of it like planting a seed; it grows into a tree that gives fruit, and each fruit has more seeds that grow into more trees. In investing, when you earn interest or returns on your investments, and you reinvest that money instead of spending it, the total amount grows faster. For example, if you invest Rs. 10,000 and earn 10% in a year, you get Rs. 1,000. If you reinvest that, next year you earn 10% on Rs. 11,000, which is Rs. 1,100. Over many years, this growth becomes much larger because your returns keep earning more returns. This principle of reinvestment and earning money from returns is the classic feature of many investments like mutual funds, PPF, fixed deposits, etc.
The formula for compounding helps you calculate how much your investment will grow over time when you earn interest or returns that are reinvested. The basic compound interest formula is,
A = P * (1 + r/n) ^ (n * t)
Where,
A = Final amount (total value of your investment)
P = Principal (your initial investment)
r = Annual interest rate (in decimal form, e.g., 10% = 0.10)
n = Number of times interest is compounded per year
t = Time in years
For example, if you invest Rs. 10,000 at an interest rate of 10% per year, compounded yearly for 5 years, the final amount for this investment will be,
A = 10,000 * (1 + 0.10/1) ^ (1 * 5) = Rs. 16,105
This means your Rs. 10,000 grows to around Rs. 16,105 in 5 years without adding any extra money and just by reinvesting the returns.
Several key factors affect the compounding effect on an asset, and understanding them can help investors grow their wealth more effectively over time.
Initial Investment (Principal) - A larger starting amount gives compounding a stronger base to grow from. The more an investor puts in at the beginning, the greater the future returns can be.
Rate of Return - The annual return or interest rate significantly affects how fast money grows. Higher returns, often found in equities or mutual funds, can accelerate compounding, though they may involve more risk compared to traditional options like fixed deposits or PPF.
Time Horizon - The longer the investment period, the more powerful compounding becomes. Investors who start early and remain invested over decades can see exponential growth, even with small but regular contributions.
Frequency of Compounding - The frequency of reinvestment of returns (monthly, quarterly, or yearly) also plays a major role in the final compounding impact. More frequent compounding directly translates into faster growth.
Consistency and Reinvestment - Regular investing and reinvesting all returns (such as interest, dividends, or capital gains) allow the compounding process to work continuously and efficiently. Skipping investments or withdrawing returns reduces this effect.
Taxes and Inflation - Both taxes on earnings and inflation reduce the real gains from compounding. Choosing tax-efficient investment options and strategies that beat inflation is essential for preserving and growing wealth.
Mutual funds and PPFs are among the most popular investment options in India and are also centred around the benefits of compounding. Let us understand how compounding works on these assets to enable better decision-making.
Consider investor A investing Rs. 5,000 per month in a mutual fund through SIP, and the average return from this fund is 12% per year. The duration of the investment is 20 years. The final accumulated amount under the fund is shown below.
The maximum investment amount in PPF is Rs. 150000. Consider an investor investing Rs. 150000 per annum in the PPF account for 15 years. The rate of return is 7.1% and assumed to be constant throughout the tenure of the investment. The final accumulated corpus at the end of 15 years, based on compounding benefits, is shown below.
Both examples show that starting early and staying invested allows compounding to work powerfully over time. In mutual funds, compounding works faster due to higher returns, while in PPF, it offers steady, tax-free growth. Investors can use the power of compounding in both options to build long-term wealth, depending on their risk appetite and financial goals.
Some of the points that can enhance or help investors maximise the benefits of compounding in their investments include,
Start Investing Early - The earlier a person starts investing, the more time their money gets to grow. Even small investments made in the early years can grow into a large amount over time due to compounding.
Invest Regularly - Consistent investments, like monthly SIPs in mutual funds, help build wealth steadily. Regular investing ensures that the compounding effect continues without breaks.
Stay Invested for the Long Term - Compounding works best over many years. The longer the money stays invested, the more the returns multiply. Avoid withdrawing investments too early unless necessary.
Choose the Right Investment Option - Select investments that match your risk level but also offer good long-term returns. For example, equity mutual funds usually give better compounding results than fixed deposits over time.
Avoid Unnecessary Withdrawals - Taking out money from investments breaks the compounding cycle. It is better to let the investment grow without frequent withdrawals, especially in long-term plans like PPF, ELSS, or SIPs.
Increase Investment Amount Over Time - Whenever possible, increase the investment amount as income grows. For example, increasing your SIP amount every year boosts the total return significantly over time.
Use Tax-Efficient Instruments - Choose tax-saving investments like ELSS mutual funds, PPF, or NPS to reduce tax outgo. Saving on tax directly translates into more money staying invested, which supports compounding.
Stay Disciplined and Patient - Finally, the key to successful compounding is patience. Avoid trying to time the market or chasing quick returns. A disciplined, long-term approach brings the best results.
The benefits of compounding are multifold and hence are one of the best ways for wealth creation in the long term. Some of these benefits are listed below.
Helps money grow faster over time
Small, regular investments can become large
Rewards long-term and disciplined investing
Ideal for building retirement savings
Returns grow without extra effort
No need for big starting amounts
Tax-saving options boost benefits
Builds good financial habits
Helps beat inflation in the long run
Compounding is a powerful tool in investing that helps money grow faster over time by earning returns on both the original investment and the returns it generates. By starting early, investing regularly, staying invested for the long term, and reinvesting earnings, even small amounts can turn into significant wealth. Thus, with discipline and time, compounding can help achieve important financial goals and build a secure future.
This topic discusses one of the fundamental aspects of investing, i.e. compounding. Although quite a popular term, investors often fail to harness its true power in achieving their investment objectives. This article is thus an attempt to demystify this concept and help investors stay ahead of the investment curve. Let us know your thoughts on this topic, and watch this space for more concepts on investing and more.
Till then, Happy Reading!
Read More: How to Calculate Returns on Mutual Fund Investments?
Marisha Bhatt is a financial content writer @TrueData.
She writes with the sole aim of simplifying complex financial concepts and jargon while attempting to clarify technical and fundamental analysis concepts of the stock markets. The ultimate goal is to spread vital knowledge and benefit the maximum audience. Her Chartered Accountant background acts as the knowledge base to help clarify crucial concepts and create a sound investment portfolio.
Thestock market never stands still, and prices swing constantly with every new h...
Process of Selecting Top Stocks for Investing The first step towards picking a ...
What is the one thing that is driven in our minds right from our childhood? It ...
