Multiply Your Investment – Realise The Power Of Compounding

Who's bothered about investing?

Tarun, 25, bagged a dream job with an IT firm in 2007. He was on cloud nine. Over the two years, he splurged his entire income, doing things he always wanted to do but couldnt because of money crunch, as if there was no tomorrow. As a result, he was left with no savings. He also got a credit card from Rupee Bank, however he was regular in his payments. Though he was aware of retirement planning, he did not see it happening for him any time soon. He was of the opinion that one should enjoy today and leave planning to tomorrow. But a small discussion changed his thinking completely. One day, he got a call from his bank; it was starting a unique education campaign on 'Power of Compounding for individuals like Tarun. Though reluctant, Tarun agreed to meet the bank representative.

What is Power of Compounding?

So what did the bank representative tell Tarun about the 'Power of Compounding'?

Compounding involves reinvesting of profits earned on your investment, thus multiplying your money manifold. Compounding is considered as the greatest mathematical discovery of all time. But the interesting thing is it is based on a very simple yet powerful concept, 'the more you delay your investment, the more you tend to lose'.

The real advantage of compounding lies in early saving and wise investing. The lower the duration of compounding, the higher will be the value of investments. This means if the compounding is done monthly instead of yearly, you will earn more money on your investments. These days, many financial institutions including banks offer fixed deposits with monthly, quarterly, semi-yearly and yearly compounding.

E.g. An investment of Rs 10,000 will grow to Rs 21,589 in 10 years at an interest rate of 8 per cent compounded annually. If the same amount, keeping the other conditions same, is compounded monthly, the final value will be Rs 22,196, a difference of Rs 607.

Early investment means higher returns

Now Tarun was interested in knowing more about compounding. He also learnt that early investment can do wonders to his money, without too much effort. He started thinking about his retirement planning and turned to the executive for further details. The executive took his example.

Suppose Tarun starts investing Rs 1 lakh annually from 2009 in a bid to build his retirement corpus, his investments, also known as annuities, will grow to Rs 5.28 cr in 2044, but if he starts investing the same amount in 2011, his investment corpus will become Rs 4.21 cr only, a whopping difference of Rs 1.07 cr.

Tarun was surprised to find out that for a late start of two years, he would have to bear a loss of Rs 1.07 cr. Moreover, he could have earned this money with a measly investment of Rs 2 lakh. This happened because Tarun was deprived of the benefit of compounding in the latter case.

Compounding vis-á-vis investment period

The bank representative further explained Tarun two cases where investments were done at different points in time. In case A, the person started investing Rs 2,000 at the age of 20 and continued investing till the age of 27. He locked all his investments till the retirement age, i.e., 60 years. In case B, another person started investing Rs 2,000 at the age of 27 and continued doing so till the age of 60. Assuming the growth rate 8 per cent per annum, the results are eye-popping (Refer Table 1).

In case A, the total investment made was Rs 16,000 (Rs 2,000 x8) which at the end of 60th year resulted into the corpus of Rs 2.75 lakh, 17 times the total investment. In case B, the total investment of Rs 66,000 (Rs 2,000 x 33) at the end of 60th year was Rs 2.49 lakh, just four times the total investment.

Effect of compounding frequency on investment

Tarun realised what he missed on by not investing in the last two years, but he vowed not to repeat his mistake and immediately start investing for his retirement age. However, he wanted to know all the aspects of compounding before he takes a plunge.

The bank executive told him that compounding period also affects the final investment, i.e., the smaller the period of compounding, the higher the net sum at the maturity period. The various kinds of compounding are daily, weekly, fortnightly, monthly, quarterly, half-yearly and yearly. Currently, different financial institutions offer different compounding methods on their deposits that help depositors earn extra returns.

Table 2 shows how an investment of Rs 1 lakh for a period of 25 years grows under different compounding methods. At an interest rate of 12 per cent, the amount becomes Rs 17 lakh under yearly compounding while the same amount grows to Rs 19.79 lakh under monthly compounding, a difference of Rs 2.79 lakh.

Summing it up

Compounding works only when an investor allows his/her investments to grow over a period of time. Tarun chose not to invest and lost his two valuable years. But he felt a sudden urge to save for his retirement when he came to know about the magic of compounding. Apart from the regular, systematic and early investment, there is one more aspect to the compounding, which is the frequency of compounding. It was clear from the examples that monthly compounding pays higher returns than yearly compounding. The bottom line, in case of compounding the amount of capital you start investing with is not as important as starting early is. Hence, the best way to secure your future needs is to start investing early.