How does compounding work in investing?

Compounding is one of the most powerful concepts in investing. It’s a way to make your money grow faster over time by earning returns not just on your initial investment but also on the returns that accumulate. Let’s understand how compounding works in simple terms and why it’s so important for investors.

What Is Compounding?

Compounding is the process where the returns earned on an investment are reinvested, allowing your money to grow exponentially over time. It’s like a snowball rolling down a hill – as it keeps rolling, it gathers more snow and becomes bigger and bigger.

For example, if you invest ₹1,000 and earn a 10% annual return, at the end of the first year, you’ll have ₹1,100. If you keep the ₹1,100 invested, in the second year, you’ll earn a return not just on ₹1,000 but on ₹1,100. This is how your investment grows faster with time.

Why Is Compounding So Powerful?

The magic of compounding lies in the fact that the longer you keep your money invested, the more it grows. The earlier you start, the greater the benefit you’ll see because the returns keep building on themselves over time.

Example:

• Start at 25: If you invest ₹5,000 every month from age 25 to 60 (35 years) with a return of 10% per year, you’ll accumulate over ₹2.3 crore.
• Start at 35: If you start the same investment at age 35, you’ll have only ₹75 lakh by age 60. That’s the difference 10 extra years can make!

How Compounding Works Over Time

Let’s look at a simple illustration:

If you invest ₹10,000 at a return of 12% per year:

• After 1 year: ₹11,200
• After 2 years: ₹12,544
• After 10 years: ₹31,058
• After 20 years: ₹96,463

Notice how the amount grows faster as time goes on. This is the power of compounding.

Tips to Make the Most of Compounding

• Start Early: The earlier you begin investing, the more time your money has to grow.
• Be Consistent: Regular investments, such as through a SIP (Systematic Investment Plan), maximize compounding benefits.
• Stay Invested: Avoid withdrawing your investment too soon to let the compounding process work fully.

Conclusion

Compounding is a powerful way to grow your wealth over time. By starting early, staying invested, and reinvesting your returns, you can achieve significant financial goals. The key is patience and consistency – the longer you let your investments grow, the bigger the impact of compounding will be.