The power of compounding — Here's why you should harness it

“Compound Interest is the eighth wonder of the world. He who understands it earns it.. He who doesn’t pays it”.

These words of wisdom do not come from any investment guru – but from a Nobel Prize winning scientist – Albert Einstein himself.

What is compounding?

Compounding refers to the reinvestment of earnings at the given rate of return to constantly grow the principal amount, year after year. The power of compounding works by growing your wealth exponentially. It adds the profit earned back to the principal amount and then reinvests the entire sum. Therefore, the interest in accrued on the principal and the previous year’s interest rather than on the principal alone.

To explain the concept, lets say you invest Rs 10,000 at 10% per annum for 10 years. Then at the end of Year 1 the interest earned will be Rs 1,000 (10% of Rs 10,000) so for year 2 the principal becomes Rs 11,000 (Principal of Rs 10,000 + Interest of Rs 1,000). The 10% interest on Year 2 will be accrued on Rs 11,000 i.e. Rs 1,100 and therefore the Principal for Year 3 becomes Rs 12,100 and so on.

Hence, at the end of 10 years, Rs 10,000 becomes Rs 25,937 – whereas if calculated on a Simple Interest basis the amount would be Rs 20,000 only! The difference of more than Rs 5,000 between simple and compounding on an investment of Rs 10,000 is a reasonable amount.

Harnessing the Power of Compounding

The best way to harness the power of compounding is by remaining invested in the right avenues for a longer period to ensure that your invested money keep earning more for you. Remember, the power of compounding can do wonders in the long term.

The Boring Stage

In the beginning, when you do one-time investment or keep investing at regular intervals, you will see your money growing at a constant pace despite of earning reasonable return. Often many investors find this phase boring as they have to give time and wait patiently to see their investments grow. This is because in the beginning the concept of return on return has just started.

The Magic Phase

Once the pace of growth increases where your reinvested amount start generating return. This is where the growth start appearing magical. In true sense, it is just the annual return earned on your principal along with reinvested return over the years resulting in the overall growth of investment. However, the key has been that you continued to stay invested for long term.

(The writer is co-founder, MyWealthGrowth.com. Views expressed are personal)