What is the Power of Compounding?

You and your friend have an exam next year which you have been planning to give for several years. As the syllabus is extensive, you started studying a year before the exam and are fully prepared for the year. However, your friend only started a month before the exam, and you know even if he studies for 10 hours a day, he will not be able to complete the whole syllabus in time. However, a little learning daily over time will help you succeed in the exam.

The same applies to investing. You can’t invest a hefty amount and hope for it to double or triple in a year. Wealth multiplication happens over time; all you have to do is ensure that you keep yourself invested. The most important thing that ensures wealth multiplication is the Power of Compounding.

Power of Compounding

In financial terms, the power of compounding is the increase in the value of an investment over time due to interest and the same interest is added back to the principal amount. The power of compounding is exercised by investors through the principle of compound interest. In compound interest, you earn interest on your principal amount, and the interest is added back to the initial principal amount again, increasing the potential interest for the next cycle.

However, the power of compounding is not restricted to just the compound interest but it extends to the idea of delayed gratification, where you add what you earn to the principal amount.

For example, investors prefer stocks over FDs as the share market has provided close to 16% returns when compared to 4-5% of FDs. As FDs come with compound interest, the power of compounding works automatically. However, with stocks, it is up to the investor when to buy and sell.

To ensure the power of compounding in stocks, they must show discipline and reinvest the profits to let the power of compounding do its magic. If the profits are withdrawn, the idea of the power of compounding becomes void as the principal amount will not get anything added to it, decreasing the return potential for the future.

Example of Power of Compounding

Consider the following example for a detailed understanding of the power of compounding.

The formula for Compound Interest: P(1 + r/100)n - P Where P is the principal amount, n is the number of years, and r is the rate of interest.

Suppose you invested Rs 1,00,000 at the age of 20, and the stock is giving you 12% interest (capital appreciation) every year. You intend to invest for 10 years and realize your total amount after the completion of the period.

Scenario 1: You withdraw the interest earned every year.

In this case, after 10 years, you would have earned Rs 1,20,000 (12,000x10) as interest. With the principal amount being Rs 1,00,000, your total investment value will be Rs 2,20,000 (1,00,000+1,20,000).

Scenario 2: You re-invest your interest every year and add it back to the principal amount.

In this case, according to the formula, you will earn Rs 2,10,584.8 as interest after 10 years. With the principal amount being Rs 1,00,000, your total investment value will be Rs 3,10,584.8 (1,00,000+2,10,584.8).

Thus, with the power of compounding, you will earn Rs 90,584.8 more than if you withdraw your interest every year.

Benefits of Power of Compounding

Here are the benefits of the power of compounding:

• It helps in multiplying the principal amount by a huge margin over time.
• It allows investors to earn returns and then increase the return potential in the next cycle.
• It requires less time with the power of compounding to multiply the investments when compared to simple interest.
• The power of compounding can be executed for any financial instrument for increasing the return potential.
• It doesn’t require extensive financial knowledge to implement successfully.

Albert Einstein once described compound interest as the “eighth wonder of the world,” saying, “He who understands it, earns it; he who doesn't pay for it.” The power of compounding is one of the most vital factors in increasing wealth over time. It is the holy grail of financial management and, if done with discipline, can allow you to garner immense wealth over time.