Early Investing and the Power of Compounding

• 24th Sep 2018
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As children in school, we often had to calculate maths sums regarding simple interest and compound interest. What seemed like simple formulae a long time ago, could actually help us a lot in our adult lives. As we grow up and join the workforce, we start to earn some money, most of which we blow on partying, good food, and date nights. As we grow a little older and have a few more responsibilities, we start to think about financial planning. Sadly, by this point, it’s already too late for us to harness the power of compounding.

So, what exactly is compounding in financial terms?

Generally speaking, compounding refers to the simple concept of earning returns on a return. This means that the longer we invest for, the more money we will accumulate. Let’s assume you’ve invested Rs. 5,000 at an interest rate of 5%, to be compounded annually. The first year, you will earn Rs. 250. This will be added to your principal amount the next year. So even without you adding any more money, your investment amount in the second year is Rs. 5,250. At the end of the year, you will earn 5% on the new amount, and so on and so forth.

When it comes to investment planning, compounding is definitely the way to go. It allows you to build up a large corpus of funds. However, there is one important factor that you need to consider. For compounding to work for you, you need to have time on your side. We can illustrate this better with the help of an example.

Suman and Sagar both joined a new firm recently. They’ve been hired at the same level, so they both earn a monthly salary of Rs. 50,000 per month. While Suman tends to spend almost her entire salary every month, Sagar is a bit more prudent, and he invests Rs. 3,000 every month in a compounding fund for 5 years. At the end of his investment plan, Sagar would have accumulated Rs. 2,52,909.

After seeing her friend do so well, Suman also decides to start investing in the same way as Sagar. Unfortunately, she’s started 2 years after him. Despite the fact that she invests the same amount, Suman will end up accumulating only Rs. 1,34,815 at the end of 3 years. Suman would have lost Rs. 1,18,094 simply because she started 2 years too late. Apart from missing out on the returns she would have accumulated for the time period, she also missed out on the opportunity to reinvest those returns into her investment, and thereby earn more.

In order to play catch up, let’s assume that Suman starts to invest Rs. 4,000 per month instead of Rs. 3,000. Let’s see how much of a difference that would make.

Despite increasing her initial investment amount, Suman still fails to earn as much as Sagar.

Time is Crucial

What we’ve learnt from the above example is that no investment amount can ever make up for the amount of time lost. Even the smallest of delays can stop you from using the power of compound interest. When Suman started investing just 2 years after Sagar, she ended up with Rs. 1,18,094 less than Sagar at the end of the investment term.

If you’d like to utilise the full potential of compounding investments, you can think about putting your savings in fixed deposits, life insurance, and mutual fund schemes. If you’d like to understand how much money you can expect to earn at the end of your stipulated tenure, you could use a power of compounding calculator, which can be found online. Please remember, all investments inherently have some amount of risk, so you’d need to educate yourself about all the risks involved before finally putting your money down.