What is the Power of Compounding in Investing?

Investment is the practise of increasing the present main amount at the highest possible rate while taking the least amount of risk possible. An investor is continuously looking for ways to increase the value of his or her money. Every investor wishes to increase the rate of return on his or her investment. Earning the best potential return is simply one component of the investment, though. There is one additional factor to consider while investing: time.

As a result, for a successful investment operation, an investor must have three factors working in his favour.

  1. Initial Investment Amount: The larger the initial investment capital, the better.
  2. Return on Investment (ROI): The higher the ROI, the higher the future value will be.
  3. Time: The longer an investor can put his money to work, the more money he will end up with.

The ‘miracle of compounding’ allows investors to maximise their wealth by combining these three elements in their favour.

Investment Compounding

Compounding is the process of increasing the value of a principal amount by combining the interest earned on the principal with the preceding interest amount. The term “compounding” refers to the reinvestment of all prior returns on investment. Compounding occurs when interest is earned on interest earned from the principal amount.

If you had invested Rs. 1 lakh 30 years ago at a ten percent annual return and reinvested the collected money, you would currently be worth Rs. 17.45 lakhs. With a 20% compounded annual return, your current net worth would be Rs. 2.37 crores. Compounding returns have taken me from Rs. 1 lakh to Rs. 2.37 crores.

The table below indicates how much your original investment (in this case, Rs. 100,000) will develop into over time at various rates of return.

Today’s initial investment is NPR 1 Lakh:

  Final Amount
Time in Years @ 10% @ 15% @ 20%
1 year NPR 1,10,000 NPR 1,15,000 NPR 1,20,000
5 years NPR 1,61,051 NPR 2,01,136 NPR 2,48,832
10 years NPR 2,59,374 NPR 4,04,556 NPR 6,19,174
20 years NPR 6,72,750 NPR 16,36,654 NPR 38,33,760
30 years NPR 17,44,940 NPR 66,21,177 NPR 2,37,37,631
50 years NPR 1,17,39,085 NPR 10,83,65,744 NPR 91,00,43,815

A look at the table above can help you understand how an investment grows over time. A person having a net worth of Rs. 91 crores may appear to be extremely wealthy (by foul play or illegal means). However, when you consider that he may have compounded Rs. 1 lakh for the past 50 years at a 20% annual return, the storey may be different. This is how the company expands over time and provides enormous value for its investors.

“The ideal business is one that earns very high returns on capital and that keeps using lots of capital at those high returns. That becomes a compounding machine.” – Warren Buffet

Finally…

An investor can reach his or her goal with compounding returns provided he or she is patient and allows the investment to grow at a reasonable rate over a long period of time. Investors’ brains are drunk with excessive expectations of doubling or triple their investment in a year in today’s financial market. We lack patience and rush through life in order to reach our goals. We overlook the fact that some things just require time to manifest. We accept riskier endeavours because we are impatient to wait, and as a result, we lose what we have accumulated thus far. The gradual and steady approach to investment will ensure success by reducing errors and increasing the end outcome.

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