What is compounding and why it works
In compounded investments you earn interest on the interest too. This magnifies the return you can earn
You may have heard about the magic of compounding. But what exactly is compounding?
Compounding refers to growth in the capital value of an investment by reinvesting any earnings back into the investment itself. Unlike simple-return investments, where a certain amount is added to the principle value at the end of each period, and at the end of term you get back the capital, in compounded investments you earn interest on the interest too. This magnifies the return you can earn.
For example, a simple interest return of 8% annually for two years on Rs1,000 adds to Rs160, which is Rs80 for year one plus Rs80 for year two. If it were compounded; at the end of year one, you would have Rs1,000 plus Rs80 is Rs1,080; and this entire amount is reinvested at 8% for year two and you would have Rs1,166.40.
Why start early
Starting early lets you remain invested for a longer period. Does it matter if you started your investment when you were 30 years old or 40? After all, even at age 40 you still have about 20 years till retirement.
Let’s say you put Rs1,000 in a 30-year 9% annual return product and your friend—who is 10 years older—invests Rs1,000 in a 20-year 9% annual return product. After 30 years at age 60, thanks to compounding, your Rs1,000 would grow to Rs13,268 and your friend’s Rs1,000 after 20 years, when she turns 60 would have grown to Rs5,604. The 10 extra years more than doubled the return because in each additional year, a higher amount was reinvested at the same rate of return.
In case of equity investments or other growth assets, the market returns differ every year. Compounding can happen on two fronts: first, price change itself is automatic compounding and if you reinvest dividends or earnings they also benefit from compounding. However, keep in mind that unlike the compounding interest on a bond, debenture or fixed deposit; returns in equity and growth assets are not linear—you don’t get the same returns every year.
If your investment is losing value then, just as price rise compounds gains, a fall in prices can compound the losses. As a result, you can lose a lot of your capital value very fast if price is falling. This means, you have to pay attention to quality of the equity stock or portfolio or the asset you are buying. Second, given the non-linear nature of the asset, you have to remain invested for long periods to benefit from compounding.