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Understanding the power of compounding in market investments
We invest to beat inflation and maximise our returns on investment. As an investor, you can leverage various time-tested strategies to get the best returns on investments. However, if you prefer to earn returns the old-fashioned, effective way, you can consider the compounding strategy. With compounding, your investments give you the best returns, and the interest earned keeps earning interest. Read on as we decode what is power of compounding.
Before talking about the power of compounding, we need to understand its foundation – compound interest. Compound interest means the interest calculated on the principal amount and the accumulated interest. Investments like mutual funds or stock markets earn profit based on compounding, hence the phrase, power of compounding.
Let us say that you invest INR 1000 in an investment scheme with a 10% average rate of returns. Your returns would be INR 1100. Instead of redeeming the profits, you keep them invested for a long time. The 10% rate would be applicable on INR 1100, where you earn INR 1210. The longer you keep investing, the better compounding works.
Compound Interest allows your savings and investments to grow faster due to interest accumulation over time. The advantages of compound interest for different financial products are:
To get a better understanding of compound interest it’s important to understand how compound interest is calculated. Here’s brief look at the compound interest formula with example.
To calculate compound interest formula you can use this formula:
A = P(1 + r/100)n – P
Where:
Suppose you invest INR 1,00,000 at an annual interest rate of 8%, compounded yearly, for 10 years.
Using the formula:
A = 1,00,000 × (1 + 0.08)10 = INR 2,15,892
Here, compounding nearly doubles your investment without any additional contributions, showing how staying invested for longer significantly enhances returns.
While compound interest offers returns on returns, simple interest provides interest on the initial principal amount only. For instance, say your investment amount is INR 1,00,000 for 5 years at an expected return rate of 10%. Consider the below table to understand the interest accrued if the interest rate is set at 10% per annum.
Year
Simple Interest (Total)
Compound Interest (Total)
1
INR 1,10,000
2
INR 1,20,000
INR 1,21,000
3
INR 1,30,000
INR 1,33,100
4
INR 1,40,000
INR 1,46,410
5
INR 1,50,000
INR 1,61,051
After five years compounding grows your INR 1,10,000 balance to INR 1,61,051 compared with a simple interest total of INR 1,50,000 so you earn INR 11,051 more, which is about 10% higher returns on the same principal without any additional investment required.
The earlier you start investing, the more you allow your investments to grow. For instance, if you invest INR 10 Lakhs with a 10% expected return rate in 2021, your investment will amount to INR 27 Lakhs in 10 years (by 2031) and INR 73 Lakhs in 20 years (by 2041). You can use online power of compounding calculators and input various permutations and combinations of the principal amount, interest rates and investment period to compute your estimated returns. To begin your journey toward long-term wealth creation, you can open a savings account online that offers high interest rates, making it easier to grow your money while enjoying the convenience of digital banking.
The power of compounding can transform even small savings into substantial wealth over time. But to truly benefit, it’s important to avoid common pitfalls that reduce its effectiveness. If you’ve ever asked what is power of compounding, understanding these mistakes is just as important as knowing how to apply it.
The earlier you invest, the longer your money has to grow. A delayed start limits the power of compounding, even if you invest larger amounts later. Use a power of compounding calculator to see how much a few early years can add to your total corpus.
Compounding works best over time. Withdrawing returns or stopping your investment midway interrupts the cycle, limiting growth. For example, pulling out from a long-term SIP too soon reduces the impact of compound interest accumulation.
Irregular investing weakens the compounding effect. Whether it’s mutual funds, FDs, or RDs, consistency is key. Regular investments allow interest to compute savings interest over a growing principal, maximising returns.
Choosing investments based only on high returns can backfire. Stability and time matter more. The power of compound interest shows its full potential in steady long-term products, even if interest rates seem modest.
To fully benefit from compounding, always reinvest interest or dividends. Growth-oriented mutual funds and cumulative FDs are excellent power of compounding examples that show how reinvested earnings accelerate wealth creation.
Compounding works on the fundamental notion that your interest earns interest. This powerful principle significantly boosts returns, especially when investing in stocks and Mutual Funds. To make the most of your savings, you can now open a bank account online with DBS Bank. With attractive high interest rates and smart mobile banking features through the DBS digibank app, it's easier than ever to grow your wealth efficiently and conveniently.
*Disclaimer: This article is for information purposes only. We recommend you get in touch with your income tax advisor or CA for expert advice.
