There are 2 ways you can make money:
- By working yourself and earning it
- By getting your money to work for you
The second option essentially means investing your money and the earlier you start the more money you’ll be able to make in the future.
How does this work?
Compounding is the answer.
When we invest a certain sum we earn interest on it either monthly, quarterly or annually. You can either take this interest back home or reinvest it. On taking it back home you’ll only earn interest on the original sum that you invested, in other words, you earn simple interest. But on reinvesting the interest you’ll earn interest on the new amount (principal+interest) and if you continue reinvesting then you’ll continue earning the interest on the new amount, in other words, you’re compounding your money and earning compound interest.
Let’s see this with an example-
You invest Rs. 1000 and get 7% interest on it yearly.
If you take back the interest every year- Year 1 you’ll get 7% on Rs. 1000 i.e. Rs. 70, year 2 also you’ll get 7% on Rs. 1000 i.e. Rs. 70, basically every year you’ll get Rs. 70.
But if you reinvest it every year- Year 1 you’ll make 7% on Rs. 1000 i.e. Rs. 70, year 2 you’ll make 7% on 1070 (Principal + interest- Rs. 1000 + Rs. 70) i.e. Rs. 74.9, year 3 you’ll make 7% on 1144.9 i.e. Rs. 80.143 and so on and so forth.
How can you make the most of compounding?
By letting it age like wine! The longer you wait the better it tastes.
Compounding works in such a way that investments start generating disproportionately higher amounts after some years. Check this example to understand it better-
As you can see every 5 years the amount grows more and more. But this growth isn’t proportionate every 5 years instead, the growth increases with time due to compounding. That’s why they say the younger you start investing the better. For instance when Sara invested Rs. 30,000 in her 30’s at 10% interest compounded per year, she earned only Rs. 77,812 on turning 40. But when Tina invested Rs. 30,000 in her 20’s at 10% interest compounded per year, she earned Rs. 2,01,825 on turning 40.
Where can you invest to see the magic of compounding?
The concept of compounding can be applied to bank deposits, bonds and even shares,
In the case of shares, equity mutual funds or any other asset that grows in value, since returns on them aren’t fixed every year, compounding is slightly different. With these assets compounding happens on two fronts- First, the price change every year itself is automatic compounding. Second, if shares give dividend and you reinvest them then you can benefit from compounding on that as well. But remember these investments could also fall in value and just how a rise in price compounds profits, a fall in prices will compound loses as well. As a result, you can lose a lot of money very fast if the price is falling. No wonder they say shares are riskier than fixed income bearing investments like bank deposits and bonds.
This doesn’t mean you must stay away from shares and equity mutual funds entirely because returns on them can be higher than usual bank deposits and bonds. Just that :
- You need to pay attention to the quality of shares you’re buying or mutual fund you’re investing in.
- Due to the unpredictable returns on the investment, you need to remain invested for long periods to actually benefit from compounding
In the case of fixed interest-bearing assets like bonds and bank deposits, the returns are fixed every year. Since these assets are usually issued by banks and governments they’re not likely to default on their interest payments. That’s why they are safer assets compared to shares and equity mutual funds that are issued by companies. But with such low risk, the returns are also low.
So to make higher returns while ensuring safety you must diversify your savings into different assets like shares, bonds and fixed deposits. If one falls the others will protect your savings.
A quick glance at the rate of return on different asset classes-
With increasing rates the risk also increases. But if you want to be extra safe then wait a few years to reach your goals.
“If you aren’t thinking about owning a stock for 10 years, don’t even think about owning it for 10 minutes”
-Warren Buffet on long-term investing.
Think of compounding like the fairy godmother for your money, just how Cinderella’s fairy godmother turned mice into horses, compounding can get you your dream house, your dream car or even that dream vacay to the Bahamas. All you need to do is save some small amounts of cash every month and with Mutual Fund SIP, you can start with as low as Rs.500 per month!
The sooner you start the better. It all depends on the time period, the initial amount invested and of course rate of interest. Compounding is proof that investing actually can make a HUGE difference. If you understood all about compounding, give a thumbs up in the comments section below!