In the world of finance, an oft repeated and widely revered word is compounding. Dubbed by Albert Einstein as the 8th wonder of the world, the magic of compounding lies in the fact that it can help investors multiply their returns over the long-term.
In the case of simple interest or returns, investors get a fixed amount of return on the principal amount originally invested.
For Example: If you invest Rs 100 for 5 years at an interest rate of 8% pa., you will earn an interest of Rs 8 each year and at the end of the 5th year you will receive Rs 100 (the principal) plus Rs 40 (Interest earned) taking the total value of your original investment to Rs 140.
In the case of compounding, not only will you earn interest on the original principal amount but also on the interest that you earn each year.
For Example: If you invest RS 100 for 5 years at an interest rate of 8%, compounded annually, you will earn an interest of Rs 8 in the first year. However, in the second year, you will earn 8% on the principal amount of Rs 100 and also 8% on the Rs 8 earned as interest in the first year. At the end of the fifth year, the total value of your investment would be Rs 146.93, which is Rs 6.93 higher than what you earned as simple interest.
The compounding effect works exceptionally well over the long-term. The overall benefits of compounding are impacted by the investment time horizon and the rate of return. It is also impacted by the frequency of compounding ie. monthly, quarterly or annually.
To truly reap the benefits of compounding, one must stay invested for the long term.