POWER OF COMPOUNDING
One wise man termed compounding as the eighth wonder of this world. Used rightly, it could be a magic wand that could transform your money into a highly powerful income-generating machine. Compounding is the process of generating earnings on an asset’s reinvested earnings. So, we require two things to make it work: the re-investment of earnings and time.
EARNINGS ON EARNINGS
The main feature of compounding is that there are earnings on the previous earnings plus the base capital. The whole idea is to build a larger base which fuels more earnings. For example, if you start out with Rs 1 lakh as an initial investment and then allow it to compound at 10 per cent per annum for the next 15 years then the base would go up to Rs 417,725. In this way the cycle goes on and the earnings keep growing.
HANDS OFF THE MONEY
The key point in the whole process of compounding is that whatever earnings come in should be reinvested. The returns should not be taken out. The withdrawal of the earnings will not allow the base of the investment to increase.
Mutual Fund & Compounding
Mutual funds are designed to help you capture the power of compounding. When the value of each unit goes up, investors make capital gains. The power of compounding helps when you invest over a long-period of time. This is because the money that you earn as capital gains also starts to generate returns. For example, if you invested Rs 1,000 per month starting today in a mutual fund, it will be worth Rs 1,63,920 in 10 years assuming a return of 8% per annum. So your investment of Rs 1,20,000 over 10 years is worth Rs 1,63,920. However, if you persist and invest for another 10 years, the money grows much faster to Rs 4,46,589. So your investment of Rs 2,40,000 over 20 years generates more due to compounding. This is the power of compounding as existing investment, returns on it and the new investment made each month all contribute to the gain.
IN A NUT-SHELL:
Compounding fuels growth of your working money by earning returns on returns. While investing maximises your earnings potential, compounding maximises the earning potential of your investments. Time and reinvesting make compounding work, so you start early and stay invested for longer time.