Compounding has to be one of the most important words in the dictionary, and every young investor needs to know this term. But the effect of compounding goes beyond just finance and works for every good habit you want to create. Let’s get started with understanding compounding.
What is Compounding?
If we talk in terms of finance, compounding is when interest is provided to an existing principal value as well as to the interest(s) already paid. The effect of this addition of value is a magnification of the amount over time, and this is the single biggest benefit of compounding.
Miracles of Compounding in Investment?
The fundamental mathematics behind compound is the compound interest formula. It calculates the new principal value, compounded to the interest, original principal value, and the period. Let’s see the formula in motion.
Consider two scenarios where you have saved $1000 and invest in any fund that gives a 7.2% growth rate per annum. Assume, you’re 20 years old as of today and you keep this invested amount for the next 50 years, that is until you turn 70. At the end of this period, you will earn $32,000 that is 32 times the original invested value.
Recommended: Old Money Vs New Money: Which One is Better?
But if you invested even later, say at 30, and kept the money invested only until your retirement, you might have got just $16,000 at the time of maturity. The lesser time you keep an investment, the lesser gain you would have got.
But this is not compound interest; the above examples are simple interests.
Assume that you have invested $1000 at the age of 20, and also invest roughly $1000 every year for the next 50 years, until you turn 70. At the end of this period, you will be left with $465,000! See the exponential gain! This is keeping the same rate of growth of the funds (7.2% every year).
Well, the concept is simple. Every year, when you invest more money, you earn interest on the principal as well as the interest gained from the previous year. This multiplies every year and results in a huge number after a long gap. The best part is, it just asks you to invest $1000 every year, which may not be significant if you earn well and keep progressing in your career.
That’s the power of compounding, and that is also why you must start it early.
Tips To Leverage the Power of Compounding
As you saw in the example above, the longer you keep the investment running, the higher will be the reward at the end of it. In fact, in many cases, extending the corpus for just 5 years almost increases your amount by many folds! The longer time you invest, the more you will earn from the already earned interest, and the amount grows faster.
Seek products that provide good investment value. If you keep your amount in a fixed deposit of a bank, it would just earn 7%. But if you choose an investment method like mutual funds, or stocks, or other high-return options, you can earn many folds. But of course, high return investment options come with their own risk.
The single most important tip to leverage the power of compounding is to be consistent. Do not stop your investment, no matter what, because that breaks the chain of compounding. Always keep a certain percentage of your income that goes towards your investment, and no matter how much your expenses rise, do not compromise on the amount you save. Figure out other ways to reduce how much you spend on needs, and/or optimize savings. The best way, to begin with, is to simply follow the 50-30-20 rule of dividing your income.
Conclusion – The Power of Compounding
There is no time better than now to leverage the power of compounding. Start with investing today, and invest any amount you are comfortable with currently. But do invest. You can always increase the amount you invest, as you grow in life career-wise and through finances. Happy Compounding!