Understanding Power of Compounding While Investing

by Nisha Ramesh  |  January 13, 2021

When you think of the most potent forces of the earth, what comes to your mind!? 

  • Gravity?
  • Internet? 

Well, they are powerful, but there is another powerful force we all come across in our daily lives but tend to ignore its power.

Yes, I am talking about the Power of Compounding. 

A genius and legend, Albert Einstein, believed that the Power of Compounding is the most powerful. 

“Compounding is the eighth wonder of the world. He who understands it, earns it… he who doesn’t pays it”. 

The power of compounding is one of the most powerful – yet least understood – and least employed concepts in the investing world. 

This piece let us delve into compounding basics and how it works like magic to grow your wealth. 

What is Power Of Compounding? 

Imagine, you have a vast piece of land and want to grow an apple orchard.

Let us say you have only a few seeds.

What will you do?

You may first prepare the land and sow the seeds, nurture them and let them grow. When these plants grow and give you fruits, you will have more seeds that can be replanted.

Did you notice what happened here?

With just a few seeds and a piece of land, you were able to grow beautiful and bountiful orchard (of course in your imagination) over time. All it required was time and patience.

This is the power of compounding.

Similarly:

In the field of investments and finance, the power of compounding works in the form of compound interest.

From the above analogy, the seeds are your initial investment, and the land is your vehicle of investment. The fruits borne on the trees is your wealth created. 

Compound interest means the interest earned when the interest on your principal investment is reinvested. You begin to gain interest on the initial interest.

This multiplies your money with speed and efficiency if given the time. It creates a chain reaction of generating wealth for as long as you are invested in it.

For example:

If you invest ₹10,000 at an interest rate of 10% today, your money will grow into ₹25,937.42 in ten years, ₹67,257 in twenty years and so on. 

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Factors Influencing Compound Interest Returns

Three primary factors influence your returns from compounding. 

  • Compounding Interest Rate

Interest earned on the investment or the returns generated by your asset.

For instance, suppose you invest in fixed deposits, the interest rate offered by your bank or financial institution is the compounding interest rate. 

  • Time

The time you give your investment to grow. The more time you let your investment build upon itself, the more it will compound. 

  • Taxation

The government effect on your investments. The tax rate applied to your investment reduces the compounding impact on it. 

Suppose your investment is tax-free or you are expected to pay tax only at the time of maturity. In that case, you will be left with more money than if you pay tax annually. 

For example:

Suppose you invest ₹10,000 in various investment vehicles (assuming tax rate at zero), the compounding effect of your investment over the years may be:

Investment Type Return on Investment (approx) Value in 10 years Value in 20 years Value in 30 years
Fixed Deposit 6% ₹17,908 ₹32,071 ₹57,434
Mutual Funds 8% ₹21,589 ₹46,609 ₹1,00,626
Equity 12% ₹31,058 ₹96,462 ₹2,99,599
Cryptocurrency 15% ₹40,455 ₹1,63,665 ₹6,60,117

Note: These return on investment percentages are for illustration purposes, and no investment decision should be made based on them.

How To Harness The Magic of Compounding?

Here are some practices you can follow to benefit the most out of the power of compounding on your investments. 

1. Start Investing Early

As some experts say, the best time to start investing was 10 years ago and the second-best time is now. 

The earlier you start investing, the more time you will afford to give your investment to grow. Thus, enabling it to compound and grow your wealth over a period.

2. Stay Committed

Consistency is the key.

Whether you earn less or more, it is advisable to make a habit of investing a certain sum of money. If you stay committed to investing consistently, the power of compounding will work magic on your investments. 

3. Patience is the key

Many investors look for quick returns in a short period. While it is not wrong to make money quickly, it does not work well for many. 

It would help if you allowed your investments to build upon themselves, without interfering from time to time. 

Once you invest a sum of money into an investment, it is better to leave it alone. Over time, when undisturbed, the initial investment will grow substantially. 

Bottom Line

The term ‘Power of Compounding’ may sound overwhelming to many. But, you need not be a math genius or a financial wizard to understand and take advantage of this force. 

Like we discussed earlier:

Compounding is a simple concept. It merely means, interest earned over interest leading to substantial returns over time. 

So, what is holding you back?

Go ahead and feel the magic of compounding on your investments. 

KuberVerse is an educational initiative. Anything expressed here directly or indirectly is not investment advice. And we ask you to do your own research before investing.


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