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The power of compounding in long-term investments

The power of compounding in long-term investments

Compound interest is the eighth wonder of the world. He who understands it earns it, and he who doesn’t pays it.”  – Albert Einstein

The concept of compounding, the process of earning interest on interest, has been around for centuries. The earliest known examples of compounding can be traced back to ancient civilisations, such as the Mesopotamians and the Egyptians, who used simple forms of compounding for lending and borrowing money. The concept of compound interest as we know it today, in which interest is calculated on both the principal and accumulated interest, was first introduced by the mathematician Albert Einstein in the early 20th century.

What is compounding?

Compounding refers to the process of generating earnings on an asset’s reinvested earnings. In other words, it’s the process of earning interest on top of interest or growth on top of growth. This can cause an investment’s value to grow at an exponential rate over time. Compounding is the reason why it’s important to start saving and investing as early as possible, as the effects of compounding can be quite powerful over a long period of time.

How can compounding help in increasing wealth?

In essence, compounding is a long-term investment strategy. Reinvestment of profits and time are two requirements for the process to succeed. Your returns begin to earn when you choose to reinvest the interest on an investment. By doing this, you are effectively turning your assets into income-producing asset that helps you build wealth. If invested in the correct assets, the “power of compounding” has the capacity to provide large profits.

Difference between simple and compound interest

Definition: Simple interest is calculated on the original principal amount of a loan or deposit. Compound interest is calculated on both the original principal along with interest accumulated from previous periods. This means that compound interest can grow much faster than simple interest over time.

Formula:

Simple Interest: (P × T × R) ⁄ 100

Compound Interest: P(1+R⁄100)t – P
Where P is principal, R is rate of interest per annum and T is time period in years.

Returns: The returns are lower in the case of simple interest, whereas the quantum of returns from compound interest calculation is higher.

Principal amount: In the case of simple interest, the principal amount remains constant, whereas, in compound interest, the principal keeps varying during the entire tenure.

Growth of funds: Growth of funds is uniform over the horizon in the case of simple interest. In the case of compound interest, the growth of funds is rapid during the tenure.

Interest charged: The interest in the case of simple interest is charged on the principal amount; on compound interest, the interest is charged on principal and accumulated interest.

Here is an example to illustrate the importance of longer tenure for gaining the benefits of compounding.

  AB
Monthly Investment Rs. 1,000 Rs. 1,000
Tenure of Investment 15 years25 years
Total Investment Amount Rs. 1,80,000Rs. 3,00,000
Compound Interest (%) 12% p.a. 12% p.a.
Total Corpus Rs. 5,04,576 Rs. 18,97,635

How can you take advantage of compound interest in your investment journey?

One way to take advantage of compound interest in investing is to invest in a diversified portfolio of assets, such as stocks, bonds, and real estate, that have the potential to earn a higher rate of return than the rate of inflation. Another way is to invest in a tax-advantaged account, such as a PF, or equity stocks / mutual funds (long term), which allows your investment to grow tax-free. Additionally, you can regularly invest through a monthly or quarterly systematic investment plan to take advantage of rupee-cost averaging.

In a nutshell:

Having understood the power of compounding, it is time you prudently take advantage of this phenomenon in your investment journey. Reach out to experts at TATA Capital Wealth to ensure you can avail optimal advantage of this phenomenon.

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