Power of compounding: The most important and the least understood principle of investing. In simple words, compounding means reinvesting the income earned from an investment at the same rate of return at which original investment was made, to increase the principal.
For example, let’s say you start with $100, and invest it @5% per year Here your principal for first year is $100. Now after 1 year you would have earned $5 as interest on this. By law of compounding, this interest would be added to your original principal of $100, so that principal for second year would become $105. This new principal would again be invested @5% per year, and this time it would earn an interest of $5.25. So, this gives you a 5% rise in your profit Year over Year.
In the starting of this article I said that this is the most important principle of investing. Let’s try to understand why. Many times we see advertisements in which people offer rates of interest that are much higher than the prevailing rates. These are misleading, because actually what they are offering is simple interest. Whereas, returns on your investments should always be seen in light of compound interest. This is for the simple reason that the interest that you have earned is also getting added to your principal to get higher returns year over year. I personally believe that there is no such thing as simple interest. This term must have been coined just to make some money from unsuspecting investors.
Another important aspect of compounding is the rate difference. Most of the times people tend to ignore small interest rate differences that different investment options offer. However, in conjunction with power of compounding, these small rate differences might make such huge impact, that it might turn out to be hard to believe.
Let’s validate this with an example. Suppose there are 2 investment options. First option offers a rate of return of 10% per year, and second option offers a rate of return of 14% per year. Here the difference in rate of return seems to be quite small. Now let’s try to see the effect that this difference has on your investment. Let’s say you decide to invest in both the plans. For both of these, you start with $200, and put $200 each month for 20 years. Below is your lump sum amount at end of 20 years for both the plans:
Plan 1 (10% per year): $144,997
Plan 2 (14% per year): $ 234,894
Unbelievable? Believe it. This is the power of compounding.
Let’s amaze you a bit more. Let’s try to see what effect the amount invested has for same rate of interest. Take three scenarios. Iny the first one, you invest $100 per month for 20 years, in second you invest $200 per month for 20 years, and in third case you invest $300 per month for 20 years. Assume rate of return to be 14% per year for all the scenarios. Below is the final amount that you get for each of the scenario:
For option 1 ($100 per month) : $144,997.
For option 2 ($200 per month) : $234,894.
For option 3 ($300 per month) : $352,342.
So, you can see that difference of just $100 each month offers a staggering difference in the amount of savings that you have at the end. Here again, power of compounding is at play.
Here, I have made 3 important points. First of all, understand that all investments must be seen in light of compound interest as there is no such thing as simple interest. Second, even small rate differences may offer substantial difference in the final amount due to power of compounding. And thirdly, even a small difference in investment amount has huge impact on your final returns, again owing to compounding.
Now that you have understood this most important principle, and have realized how powerful this is, please start applying this to all your investment plans. This would ensure that you make your investments work for you, and not you working for your investments.