Compounding is a method where interests earned on the investment get reinvested alongside the original investment. That makes the interest a part of its principle. In this manner, its initial investment capital keeps going higher, and the overall process of earning remains a continuous process. The earning happens on the invested capital.
So, it goes without saying that compounding is a process of earning interest on interest. It leads to what is more prominently known as the miracle of compounding. That makes it more difficult from the simple interest (paid only on principle). It’s also why the compound interest scales up the overall investment value much faster than the simple interest.
Nonetheless, it may also prove to be the downside for people who borrow under a compounding principle. The debt burden increases as its interest accommodate the previous interest charges and unpaid principle, just like the earnings would if you had invested.
So, the compounding periods may be monthly, daily, or even annual. And it gets performed with the bank’s savings book, where the total interest gets calculated as the compound interest.
So, how does compounding work?
To get an insight into how compounding works and how to calculate compound interest, you need to consider learning an example.
Suppose you have invested Rs. 10,000 in a particular scheme that provides you with 5% of the annual interest pay-out. Upon the initial compounding period (that’s your first year), the total amount in a savings account rises to five hundred more than the original amount. So, it’s Rs. 10,500. So, it’s basically the 5% of the original amount that works out to Rs. 500 by interest. And it gets added to your principal. As soon as you reach the second year, that’s where the compound interest comes into play.
Upon the second compounding year, the total amount in a savings account rises to Rs. 10,500. So, it witnesses a growth of 5% that works to around Rs. 525. After this amount, the balance rises to Rs. 11,025. Now, the 1st year’s interest earnings and principal witness an upsurge in the growth. Now, if you think you only got Rs. 25 more in the 2nd year when compared to the first one; you are mistaken. If you calculate this via simple interest, an additional accrual is just zero. So, you might have earned interest in the flat Rs. 500, just like the initial year and not 25 more as in compounding.
In compound interest, the longer the period of time given to the invested amount, the greater the potential for accelerating returns on the investments. So, as soon as the third year is over, your balance is Rs. 11,576.25.
Compounding in the stock market
In simple words, there is no compounding in the stocks on a regular bank deposit line. Here, the rate of interest through the compounding principle is applicable for companies. However, on the other hand, the mutual funds are designed in such a manner to extract the maximum. Here’s what you must learn about compounding in mutual funds and stocks.
1. Compounding in the mutual funds
Mutual funds exploit the idea of compounding, where a fund manager will reinvest the overall profits earned in an underlying scheme. That can help generate high returns than anyone expects from the dividend option of the fund.
When you increase the investment by degrees every successive year, the compound interest with the mutual fund gets calculated on a new investment alongside the investment & returns.
2. Compounding in the stocks
Compounding is more complex when it comes to stocks. And it’s less cut and dried in comparison with the predetermined return from the bank deposit. In general, there is no rising value. It’s just the value of a stock that you hold, and it gets compounded.
Optimizing the compounding benefits
To receive the maximum, you need to fall back on the thumb’s rule of investing. Let’s not waste time and learn them in brief from the following:
- You need to first start early
- The next thing to perform is to set the objectives & stay disciplined
- The last and the final thing is to hold patience
With these things kept in mind, you will be able to optimize the compounding benefits. Let’s consider the initial rule when you start to invest the moment you get assured of the regular income offer you a chance to expand your assets or wealth. A fresher at the age of 25 is going to have a head start on someone who starts investing at the age of 35. And even if that does not convince you, always remember that the legendary Warren Buffett started investing at the mere age of 11.
No one can get rich overnight. So, remember that it’s only the long-term investments that will benefit from compounding. You will require patience to let the investment grow steadily.
As long as you have goals in your mind, it keeps you on the right track. So, stay disciplined about investing, irrespective of how small the income is.
Finally, the key rule in any kind of investment is to have a basic understanding of how the returns accrue from what you invest. And compounding involves realizing the fact that you require having a long-term horizon. But remember that you might lose money rapidly when you invest in the shares that lose value instead of gaining something. That’s the reason it is imperative to study the basics of a company where you are investing.