Compounding is the ability of an asset to generate earnings that can be reinvested to generate further earnings. The benefits of compounding are so compelling that it has been called the eighth wonder of the world.

“Compound interest is the eighth wonder of the world. He who understands it earns it… he who doesn’t… pays it,” goes a famous statement that is often attributed to Albert Einstein.

Well, we don’t know if he said that for sure. But what we can vouch for is that those who can understand the compound effect and harness the power of compound interest in investments will reap rich benefits. Well, literally!

The power of compounding: Small savings, Large Returns

Before understanding how compound interest can help us, it may be helpful to understand how compounding as a principle works. Have you ever saved up little change and tossed it in a piggy bank? We all do that to get rid of small change that often takes up space in wallets! What happens once the ‘bank’ is full and you count all the small change? More often than not, you’ll be surprised to see that it has added up to a lot! That’s compounding at work!

Illustrating the Compound effect

Let us say that you invest rupees 100 and earn 10% interest per annum. At the end of the year, you earn 10 rupees as interest. You withdraw that interest amount. Each year then, you earn 10 rupees as interest. At the end of 10 years, you have earned 100 rupees as interest, and your capital amount stands undeterred as well. This example shows simple interest at work.

Now, let us see the power of compounding. Let us assume that you did not withdraw the 10 rupees interest in the first year and added it to your capital. In the second year, you earn Rs. 11 as interest since your capital amount is 110. In the third year, you will earn rupees 12.1 as interest. If you continued reinvesting the interest earned, after 10 years, you would make a total interest of 160 rupees. And, of course, your initial capital of 100 rupees will remain unaffected and safe.

In the above example, you can see the compound effect at work. You have earned compound interest in the investment of the principal sum and the interest earned.

Can it work for me?

Yes, it can. If you want to harness the power of compound interest, here is what you must keep in mind:

1. Time: Investing early is one of the key ways to leverage this effect. It works best with a more extended time horizon. As can be seen from the example, time is a crucial factor. The earlier you start investing, the more time-scope is available for the magic to work.

2. Staying invested: The principal amount remains invested. The interest amount is added to this and the entire whole, then reinvested to benefit from compounding.

3. Increased compounding periods help: As the frequency of compounding increases, so will the benefits. So, compound interest calculated half-yearly would be more beneficial than that calculated annually.

Financial Instruments

Suppose you’re convinced about the power of compounding. In that case, the next question you may have is what financial instruments will help you get the best of compounding. Many schemes offer dividend reinvestment plans that work on this principle. In fact, the premise of Systematic Investment Plans or SIPs also considers some of the principles of compounding. Depending on the SIP you choose for your portfolio, you may be able to capitalize on compounding.

Paison ki Seedhi Baat

“Little by little one travels far” goes a popular adage. Remember that the compound effect and the concept of compound interest will work for you in the long run if you harness its power right now. Download the MyMoney app to track your monthly expenses and start saving more to benefit from compounding starting today.