Topic 4: What is compounding?
When anyone talks about investing, they say “Don’t work for money. Make money work for you”. And how does money work for you? It’s through compounding. What is it?
How is it useful?
Now look at it in the world of investments. Let’s say you invested Rs. 10,000 in a deposit which pays an interest rate of 10 per cent annually. You don’t opt for the payout of interest. In the first year, the interest earned is Rs. 1,000. You now have Rs. 11,000 (Rs. 10,000 + Rs. 1,000). This total amount will earn interest in the second year.
That results in an interest of Rs. 1,100. What is happening is that the Rs. 1,000 that you earned in the first year is in turn earning Rs. 100 in the second year. So at the end of the second year, you have Rs. 12,100 in your hand. By the end of year 10, the Rs. 10,000 would have grown to Rs. 25,937.
Mutual fund returns work in the same manner. Let’s say you invested Rs. 1 lakh in two mutual funds with NAVs of Rs. 10 and Rs. 250 respectively. A year later, both the funds’ NAVs rose by 10 percent to Rs. 11 and Rs. 275. Your investment is now worth Rs. 1.1 lakh. At the end of the second year, both funds again saw their NAV rise by 10 per cent. Their NAVs now become Rs. 12.1 and Rs. 302.5. The value of your investment has thus grown to Rs. 1.21 lakh.
The power of compounding is felt over a long period of time and not in a couple of years. This is why you are always told that the earlier you start investing, the better it is for you.
Of course, compounding is also greater when you invest higher sums at the outset. So if you had invested Rs. 2 lakh in the above example, by year 10, you would have Rs. 5.18 lakh. The Rs. 1 lakh differential in the investment amount reaps a difference of Rs. 2.59 lakh in return.
How is it useful?
Now look at it in the world of investments. Let’s say you invested Rs. 10,000 in a deposit which pays an interest rate of 10 per cent annually. You don’t opt for the payout of interest. In the first year, the interest earned is Rs. 1,000. You now have Rs. 11,000 (Rs. 10,000 + Rs. 1,000). This total amount will earn interest in the second year.
That results in an interest of Rs. 1,100. What is happening is that the Rs. 1,000 that you earned in the first year is in turn earning Rs. 100 in the second year. So at the end of the second year, you have Rs. 12,100 in your hand. By the end of year 10, the Rs. 10,000 would have grown to Rs. 25,937.
Mutual fund returns work in the same manner. Let’s say you invested Rs. 1 lakh in two mutual funds with NAVs of Rs. 10 and Rs. 250 respectively. A year later, both the funds’ NAVs rose by 10 percent to Rs. 11 and Rs. 275. Your investment is now worth Rs. 1.1 lakh. At the end of the second year, both funds again saw their NAV rise by 10 per cent. Their NAVs now become Rs. 12.1 and Rs. 302.5. The value of your investment has thus grown to Rs. 1.21 lakh.
The power of compounding is felt over a long period of time and not in a couple of years. This is why you are always told that the earlier you start investing, the better it is for you.
Of course, compounding is also greater when you invest higher sums at the outset. So if you had invested Rs. 2 lakh in the above example, by year 10, you would have Rs. 5.18 lakh. The Rs. 1 lakh differential in the investment amount reaps a difference of Rs. 2.59 lakh in return.