Power of compounding

Mustafa Jawadwala explains how compounding can hasten wealth accumulation 

Albert Einstein called compounding “the greatest mathematical discovery of all time” that can be applied to everyday life. Compounding refers to the multiplier effect in a long-term investment strategy.

Compound return can be achieved when an investor invests a sum of money regularly for a certain period and the periodic returns too are reinvested which in turn gives additional earnings.

Instead of withdrawing interest earned on the money, it gets added to the principal and the return the next year is earned on the larger amount – principal plus interest. In the subsequent year, the rate of return is on the larger principal sum. The longer the period of investment, the bigger the wealth accumulates.

Compounding works on two basic principles - reinvestment of earnings and period of investment.

Comparison of Simple Interest and Compound Interest

The power of compounding has an amazing effect on wealth accumulation. The table below shows return on Rs 10,000 invested for 10 years to 30 years based on 12 per cent simple interest and 12 per cent interest compounded yearly as well as quarterly.

Type of Return	10 yrs (Rs.)	15 yrs (Rs.)	20 yrs (Rs.)	25 yrs (Rs.)	30 yrs (Rs.)
Simple Interest	22,000	28,000	34,000	40,000	46,000
Compound Interest (Yearly)	31,058	54,736	96,463	1,70,001	2,99,599
Compound Interest (Quarterly)	32,620	58,916	1,06,408	1,92,186	3,37,109

 

  

In simple interest, investor earns interest only on the principal, whereas in case of compounding, interest is earned on the principal amount and additionally on the interest earned year-after-year.

 

If Rs 2,000 is invested every month in a fund that can earn a return of 9 per cent, the investment will grow to Rs 3, 89,000 after 10 years. If the same amount is invested for a period of 30 years, the amount will increase to Rs 36.88 lakh.