compounding3-min

Power of Compounding

In Financial Planning, Financial Tools by Mitul Daga and Urvi Khara0 Comments

Compounding is where returns made on an investment are reinvested in order to generate subsequent returns of their own. Although it is a very simple concept theoretically, most people fail to understand its impact over a period of 25-30 years.

Let us take a small example: If we invest ₹100 now, we get ₹10 as interest for this year and our investment grows to ₹110. But the next year, the interest we get is 10% of ₹110 i.e. ₹11. So, we get interest not only on our principal amount (₹100) but also the interest (₹10) we have earned so far. This interest keeps on increasing as the value of our investment increases.

The effect of compounding can be seen through the following example, where we have considered four scenarios:

Rate of return has been assumed to be 10%.

A B C D
Starting age 25 years 30 years 35 years 40 years
Monthly investment ₹ 8000 p.m. ₹ 10000 p.m. ₹ 13333 p.m. ₹ 20000 p.m.
No. of years invested 25 20 15 10
Total amount invested ₹ 24 lakhs ₹ 24 lakhs ₹ 24 lakhs ₹ 24 lakhs
Accumulated amount at 50 years ₹ 99.45 lakhs ₹ 72.39 lakhs ₹ 53.55 lakhs ₹ 40.29 lakhs

You can see how investing the same total amount but for different time periods can lead to highly varying returns.

If you are still not convinced, look at our 2nd example:

Here, A started investing at age 25: ₹ 1 lakh every year for 10 years. He keeps his money untouched till age 65

B invests from age 35 (10 years late): ₹ 1 lakh every year for 30 years.

A B
Starting age 25 35
Yearly investment ₹ 1,00,000 ₹ 1,00,000
No. of years put in 10 30
Total amount invested ₹ 10 lakhs ₹ 30 lakhs
Rate of return 10% 10%
At the age of 65 years ₹ 3.06 crore ₹ 1.81 crore

As you can see, B’s investment is 3 times that of A, but A’s corpus has accumulated to ₹3.06 crore whereas B’s corpus stands at ₹1.81 crore.

This shows how lesser but early investments accumulate to larger amounts than higher investments later on. A gap of just 10 years makes a large difference to your corpus.

Compounding gets really great when it teams up with time. Investing early is the key to wealth creation.

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