Understanding the Magic of Compounding
Napoleon Hill author of best seller ‘Think and Grow Rich’ is often credited as saying that ‘Make your money work so hard for you; so that you do not have to work for it.’ Various books have been written on the art and science of making money based on more or less the same principle.
Mathematically speaking ‘Make money work for you’ is called as compounding or simply compound interest. Albert Einstein was amazed by the power of compounding and called it the eighth wonder of the world.
Before we move on to identifying financial goals and how to achieve them it is important to understand the power of compounding and regular saving.
Understanding compounding
Regular saving in relatively safer financial instruments yielding moderate returns can work wonders over a long period of time. If a parent starts saving Rs 25 daily for their child from the day he or she is born for the next 25 years at a rate of 10 per cent compounded annually, they would be able to gift the child an amount of Rs 9.25 lakh on his 25th birthday.
Apart from the money the amount will teach the child the advantage of savings. If he learns to save and invest in the same way as his parents and from the age of 25 years starts investing Rs 3,000 per month religiously in the same instrument earning 10 per cent compounded annually he would be able to get an amount of Rs 1.14 crore at the time of his retirement (60 years).
Besides that, by increasing one’s SIP amount with rising income, an investor is investing more money, which may help in long term wealth creation with the added advantage of compounding. A top up facility can help his corpus grow and reach his financial goals faster.
Compounding works wonders over longer period
Compounding teaches us that it does not take too much of money to save a decent amount. What is required is the discipline of regular saving and time on your side. Longer the time better will be the return. Let us understand the magic of compounding with the help of an example. Suppose there are two investors Mr A and Mr B who are looking for opportunities to create wealth. They spot an opportunity where interest can be earned at the rate of 10 per cent. Both of them decide to stay invested for a period of 10 years. Investor Mr A opts for interest being calculated as compound interest while Mr B opts for interest being calculated as simple interest. At the end of 10 years, Mr A accumulates a corpus which is Rs 59,374 higher than Mr B’s corpus.
Particulars Mr A Mr B
Principal Amount Invested Rs 1,00,000 Rs 1,00,000
Rate of Interest 10 per cent 10 per cent
Duration of Investment 10 years 10 years
Amount at Maturity Rs 2,59,374 Rs 2,00,000
Note: This is for illustration purposes only. Calculations are based on assured rate of return and actual return on investment can be more or less that has been used in the illustration. CAGR, all figures are rounded.
Once you learn about the magic of compounding, it’s natural to want this magic to work towards building your wealth. To truly benefit from compounding interest, it is important to start investing early. The earlier you start investing, the greater the accumulated return on your original investment. It is not only about how much money you put in, but also how much time you have to let your money work for you. Compounding and goal planning
Financial goal planning must be on a steady and assumed return. Starting to save early in life prevents us from taking riskier bet. It is harder for your savings to catch up with your needs if you start investing later. An Investor Education & Awareness Initiative
An Investor Education & Awareness Initiative by HSBC Mutual Fund
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