What is Compounding?

Compounding is called the eighth wonder of the world and is one of the most important concepts of finance. If you want to earn long term wealth from your investments then it becomes very important for you to understand the principle of compounding. That is why through today’s article we will try to make you aware of the importance of compounding and how it works.

What is compounding?

Compounding means getting interest on your investment and its interest. Compounding is the process in which after receiving interest on the value of your investment, you get interest only on the total value created next time. Such a process continues throughout the time period of your investment and after some time leads to a situation where the value of the investment increases very rapidly. This is the reason why time is very important in the principle of compounding. The longer the investment is made, the better or better the effect of compounding will be seen.

If you are already investing or are thinking of doing so, then keep in mind that whatever instrument you are investing your money in, there should be interest compounding, that is, you get the benefit of compound returns instead of simple returns. . With the help of compounding, very good returns can be earned in the long term on investments made in instruments like stock market investment or SIP in mutual funds.

How does compounding work?

The principle of compounding helps your investment grow much faster. Let us try to understand this with the help of an example.

Suppose you have invested Rs 100,000 somewhere and you have to get 10% interest on it every year. After the first year, you will get interest of Rs 10000 on Rs 1 lakh and the value of your investment will become Rs 110000. Now when interest will be charged on it in the second year, it will be charged on the amount of Rs 110000 and not on Rs 100000. That is, after the second year, the total interest you will get is Rs 11000 and the value of your investment will be Rs 121000. In this way, due to the increase in the value of interest you get through compounding every year, your principal amount will also increase and the higher the principal, the higher the interest. The more you will get. After a time, your investment value will increase very rapidly but the only condition here is that you have to hold the investment for a long time and avoid withdrawing the money in any way.

Compounding formula

The following formula is used to calculate compounding:

A = P(1 + r/n)^(nt)

A: Future value of investment

P : Principal Amount

R: Annual interest rate

N: The time for which the amount is to be compounded

T: Total time period of investment

According to the above example, we have invested Rs 100000 in some instrument for 10 years where we are to get 10% compound interest. According to the formula, our investment value after 10 years will be:

A= 100000(1 + 10/12)^(12*10)

A = 259,374/-

Importance of Compounding

Everyone has thought about saving something for different purposes of their life. Be it children’s marriage, retirement or buying a house or car. For these situations we need lump sum money, which is not possible for everyone to arrange at once. Therefore, it is important to start planning for such a purpose in advance and the sooner you start planning and investing, the sooner you will get the benefits of compounding.

An important thing to keep in mind in investing is whether the returns received on it can beat the inflation rate or not. We all know that with the passage of time the value of money decreases, that is, the goods that we get for Rs. 100 today may cost us Rs. 200 after 5 years. Similarly, if you have thought that the house you want to buy after 5 years, whose price today is Rs 25 lakh, may increase to Rs 32 lakh in the future. In such a situation, even if you are saving money for your dream house, compounding further strengthens the fact that the money we are investing grows at the same rate as the inflation rate and gives better returns.

Keeping such facts in mind, we can say that compounding is very important in any field of investing, be it stock, mutual fund or bank FD.

Helpful tips in compounding

Start early: You get benefit in compounding only when you hold your investment for a long time. So if you want to save money for your retirement or any other planned purpose, then start your investment plan as early as possible.

Stay Invested: The real magic of compounding can be seen only when you remain continuously invested in your investments. Therefore, it is important that you do not withdraw your invested amount out of fear of market fluctuations and remain invested for as long as possible.

Pay attention to the returns: Make sure that whatever instrument you are investing in, the returns given by it should be such that even after tax is deducted, it matches the inflation rate. For example, you are investing in a bank FD where you are getting 7% interest. Although it would seem that 7% interest is appropriate, but tax will also be applicable on this interest and after deducting the tax, this return will not remain 7%. Therefore, invest in such instruments which give you more returns than fixed returns so that even after tax is deducted, you can accumulate a good amount.

Choosing the right investment: As already mentioned, to get good returns, invest in such an instrument which gives you such returns which can beat inflation in the long term. If you can take some risk then you can invest in mutual funds or stock market and for those who take less risk, instruments like bonds etc. may be suitable.

Keep a long term perspective: If you get into investing, always take a long term perspective because returns in instruments like mutual funds are not fixed and can be more or less in the short term. But if we think long term then the average returns turn out to be much better than fixed income instruments.

Conclusion – Conclusion

Even a small regular investment can make you rich with the help of compounding. In compounding, it is not so much important how much you are investing but what matters is how long you are investing. If you have some goals in your life, then start saving from now to fulfill them. Give and invest in such instruments in which you get the benefit of compounding.