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# The Power of Compounding

## Compounding of returns means that time is the most valuable asset that an investor has.

india Updated: Aug 25, 2015 12:15 IST

Compounding of returns means that time is the most valuable asset that an investor has.

There are two kinds of investors in this world, those who understand compounding and those who don’t. Almost everyone who invests money claims to understand compounding but very few do.

In a way, that’s an unfair accusation. Compounding produces such unintuitive results that perhaps only a few mathematical geniuses can be expected to have a real feel for it. The rest of us must rely on calculations. Try to answer this question. What will grow your money more? 10% a year for 15 years or 33% a year for 5 years? The answer is that the two will earn the same amount, about 4.18 times the principal invested.

To understand how, we need to define compounding. Textbooks and Wikipedia, define the term ‘Compound Interest’ as follows – ‘Compound interest’ arises when interest is added to the principal, so that, from that moment on, the interest that has been added also earns interest. This addition of interest to the principal is called compounding. Although we use the word ‘interest’, the process of compounding applies equally to all forms of returns, not just those that are called interest.

The biggest thing that investors should appreciate about compounding is the enormous value of time. As your returns themselves start earning, and then the returns on those returns themselves start earning, the profit starts piling up at a much higher pace.

Example – Growth of Rs.1 lakh if interest paid @ 10% per annum

 Years 5 10 15 20 25 30 Rs.1 lakh grows to (Rs. Lakhs) 1.61 2.59 4.18 6.73 10.83 17.45 Compounding Effect (Rs. lakhs) 0.61* 0.98^ 1.58 2.55 4.11 6.61
* 1.61-1=0.61, ^2.59-1.61=0.98

In the above example, Rs.1 lakh invested over periods of 5, 10, 15, 20, 25 and 30 years translates into maturity amounts ranging from Rs.1.61 lakhs after 5 years to Rs.17.45 lakhs after 30 years. The compounding effect is clearly visible as the extra amount earned in each of the 5 years is exponentially rising. Gain in the first 5 years is Rs.0.61 lakh while in the next 5 years is Rs.0.98 lakh. This increases to Rs.2.55 lakhs between the 15th and the 20th year and 6.61 lakhs between the 25th and the 30th year.

Translated into a human lifetime, it means that someone who saves for 30 years earns over 17 times the principal compared to someone who saves for 20 years and earns only 7 times the principal and so on. If one has time to learn just one thing about investing, then it should be this. In short, one needs to start saving early and for longer periods of time to achieve the full power of compounding.

Summing up

Compounding means that the returns on investments themselves become part of the investments and start generating returns. The arithmetic of compounding means that investments start generating disproportionately higher amounts after some years. This makes long-term investing especially rewarding.