The Power Of Compounding In Investment
SOM THAPA
Investment is a process of increasing the current principal amount at a higher possible rate with a minimum risk. An investor always strives to grow his/her money. The dream of every investor is to achieve a higher rate of return on his/her investment. However, earning the highest possible return is only one aspect of the investment. There is one more aspect of investment-Time.
Hence, for successful investment operation, an investor should have 3 things in his favor.
1. Initial Investment Amount: The more initial principal amount, the better.
2. Return on Investment: The higher the return on investment, the larger the future value will be.
3. Time: The longer the investor can put the money into work, the larger his final sum will be.
With these three factors working in the investors’ favor, the maximization of wealth is possible through the ‘miracle of compounding’.
Compounding in Investment
Compounding, generally, refers to the growing value of a principal amount with the interest earnings on principal amount and previous interest amount. Compounding implies that all the previous return on investment is reinvested. When you earn interest on your interest earned from the principal amount, that is compounding.
If you had invested Rs. 1 lakh at 10% return per annum 30 years ago and reinvested the accumulated interest along the way, you would be worth Rs. 17.45 lakhs as of now. At 20% compounded return, your current net worth would be an impressive Rs. 2.37 crores. From Rs. 1 lakh to Rs. 2.37 crores, is the miracle of compounding returns.
The table below shows how much your initial investment (Rs. 100,000 in this case) will grow into in different time periods at various rates of return through the process of compounding.
Initial Investment Today: Rs. 100,000/-
| Final Value | |||
| Time (Years) | @ 10% | @ 15% | @ 20% |
| 1 | 1,10,000 | 1,15,000 | 1,20,000 |
| 5 | 1,61,051 | 2,01,136 | 2,48,832 |
| 10 | 2,59,374 | 4,04,556 | 6,19,174 |
| 20 | 6,72,750 | 16,36,654 | 38,33,760 |
| 30 | 17,44,940 | 66,21,177 | 2,37,37,631 |
| 50 | 1,17,39,085 | 10,83,65,744 | 91,00,43,815 |
Looking into the above table helps to realize how an investment grows over time. A person with a net worth of Rs. 91 crores may look like he has become rich overnight (by foul play or illegal means). But the story may be different when you know that he may have compounded Rs. 1 lakh for the past 50 years at 20 percent annual return. That’s how the business grows over time and creates immense value for its shareholders.
As Warren Buffett quips, “The ideal business is one that earns very high returns on capital and that keeps using lots of capital at those high returns. That becomes a compounding machine.”
Conclusion
With compounding returns, an investor can achieve his goal if he/she remains patient and let the investment grow at a decent rate for a long period of time. In the current financial world, the minds of investors are intoxicated with unrealistic expectations about doubling or tripling their investment within a year. We lack patience and hurry through our life to achieve what we want. We fail to realize that some things just take their time to manifest. With the impatience to wait, we take riskier endeavor, thereby losing everything we had accumulated so far. In investment, the slow and steady process will guarantee success through the minimization of errors and the maximization of the result.
Compounding interest is good option in a stable economy, in a volatile market like ours, where inflation is almost 10 percent every year how do you justify compound investing?
How to invest?
Compounding is more justifiable and necessary to curb the malice of inflation. Had there been no inflation, people would not have to worry much about compounding. Normal savings would work.