What Is Compounding?

Creating wealth is no fluke or luck by chance; it is an art and can be achieved only by clever handling of available resources. Discipline and patience are the paths to good wealth management and accumulation. The amount of investment does not matter, but the regularity matters to ensure you will create a corpus that will suffice your financial goals. We tend to ignore the power of compounding which is the key to building up the great corpus.

There is a famous saying by the genius Albert Einstein, “Compound Interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.”

Power of compounding

In simple terms, it means earning interest on interest which leads to growth in your savings and investment. No matter how small the amount, the key is the duration of the investment. In the below table, there is an example of how a yearly investment of INR 10,000 grows year after year at different interest rates.

Year	Principal (INR)	Interest (INR)
		8%	10%	12%
1	10,000	10,800	11,000	11,200
2		11,660	12,100	12,540
3		12,600	13,310	14,050
4		13,600	14,640	15,740
5		14,690	16,110	17,620
6		15,870	17,720	19,740
7		17,140	19,490	22,110
8		18,510	21,440	24,760
9		19,990	23,580	27,730
10		21,590	25,940	31,060

It can be clearly seen from the above table that how an investment of INR 10,000 triples after a span of 10 years at a compound interest rate of 12% p.a. The amount will double if the rate compound rate of inertest is 8%.

What is Compounding Interest?

The main feature or advantage of compounding is that it produces earning on previous profits along with the base capital. The ultimate goal is to build a large base which keeps adding on the profits. Compounding creates a cycle of earning which continues to grow. For example, if you invest INR 1 lakh at the rate of 10% for 15 years, then you will have a base of INR 417,725.

The main crux of compounding is that the earning generate has to be re-invested back until maturity. An investor should never redeem the profit or withdraw returns this will have an impact on the growth of the investment.

Compounding in Mutual Funds

Mutual funds are constructed in such a manner that they can be benefited from the power of compounding.  The investor will be able to make a profit when the unit price of the mutual fund rises. For long term investments, the power of compounding helps the investment grow, especially in the case of mutual funds where the money that is generated in form of capital gains makes more profits for the investor.  An investment of INR 1000 in a mutual fund SIP calculated at the rate of 8% annually will see a sum of INR 1, 69,920. So, an investment of INR 1, 20,000 over a period of 10 years will return INR 1, 63,920. Now, if the investor chooses to further invest it for another 10 years, then the re-invested money will grow even faster and give returns of INR 4,46,589. This is the magic of compounding, where the existing investment along with returns, in addition to the new investment every month- all of them contribute towards further gains.

Power of compounding on investment of INR 1 lakh a year for 5 years
Year	Opening balance (INR)	Investment (INR)	10% interest (INR)	Closing balanced (INR)
1	–	1,00,000	10,000	1,10,000
2	1,10,000	1,00,000	21,000	2,31,000
3	2,31,000	1,00,000	33,100	3,64,100
4	3,64,100	1,00,000	46,400	5,10,500
5	5,10,500	1,00,000	61,000	6,71,500
Total investment: INR 5,00,000 | Interest earned: INR 1,71,500  | Value after 5 years: INR 6,71,500

If you take the compound interest factor out of the above example, then an investment of INR will earn you only INR 50,000 in interest at the rate of 10%. The difference made by compounding is more than 3 times of the simple interest.

Benefit of compounding can be achieved by following these key rules.

a. Make an early start

Investment should be started from the first day a person starts earning. There are various options in the market like mutual funds, ULIP etc. for a young investor to create a solid base that will help in reaching big financial goals.

b. Discipline

To build a healthy investment portfolio, an investor needs to define his/her financial goals and priorities. Irrespective of how much a person earns, knowing the financial goals and priorities will help to get into a discipline of investment which will pay off later. Discipline is key to building a large corpus and realising financial goals.

c. Be patient

In a fast paced environment, everyone is looking to redeem quickly to fund a demanding lifestyle. They don’t realise that the power of compounding benefit is achieved only in long term investments. You need to give time to your investments to help it grow at its own pace without disturbing or breaking the compounding effect.  Only years of discipline and dedication on the part of the investor will help to create a healthy lump sum amount.

d. Keep a tab on your spending

To inculcate savings in our life, we need to keep a tab on our spending. It is important to know where to spend and where not to spend your money. Budgeting your monthly expenses is important to ensure you have always room for savings. If spending is done wisely, then it will make way for regular investments in mutual funds, ULIPS etc.

If you begin investing INR 1 lakh a year & increase your investment by 10% every year, this is how compounding interest will help your money grow
Year	Opening balance (INR)	Investment (INR)	10% Interest (INR)	Closing balance (INR)
1	–	1,00,000	10,000	1,10,000
2	1,10,000	1,10,000	22,000	2,42,000
3	2,42,000	1,21,000	36,300	3,99,300
4	3,99,300	1,33,100	53,240	5,85,640
5	5,85,640	1,46,410	73,205	8,05,255
Total investment: INR 6,10,510 | Interest earned:  INR 1,94,745 | Value after 5 years: INR 8,05,255

Compounding in ULIPS

ULIPs have gained popularity over the last few years with the insurance and investment component in it. Through regular investment in ULIP, an investor can get an advantage of rupee cost averaging and power of compounding.

Below is an example of compounding of pounding in ULIPS

4 investor A, B, C and D invest in share market Sensex index on 1^st day of the month at different time periods. The portfolio was review on Dec, 31, 2017.

Investor	Start date	investment amt per month	Time period of investment	Total investment	Total units purchased	Market value of investment
A	1st Jan 2008	5000	10	6,00,000	50.73	1073914.56
B	1st Jan 2013	10000	5	6,00,000	17.93	379583.98
C	1st Jan 2015	16667	3	6,00,000	9.82	207795.56
D	1st Jan 2016	25000	2	6,00,000	6.5	137579.39

As we can see from the above example, compounding helps your investment grow into a big corpus. Be it mutual funds, ULIPS or any other kind of investment, the power of compounding is a huge benefit, if it can be inculcated in the design of an investment.