Power of Compounding and SIP

 

power of compounding

Albert Einstein once said, “Compound interest is the 8th wonder of the world. He who understands it earns it and he who doesn’t pays it.”

As the great scientist mentioned, when it comes to investing for wealth creation, the biggest differentiator is the Power of Compounding. The best part is that it is certainly in your hands to make the most of this opportunity. Let us explore the power of compounding in detail.

Power of Compounding

In simple words, the power of compounding means earning interest on investment, and the same interest is added back to the principal amount. Let us take an example to understand the power of compounding.

If you invest ₹1 lakh in one instrument giving compound interest and another ₹1 lakh in an instrument giving simple interest, at the same time. Both investments are giving 10% interest per annum for a period of 10 years each.

Particulars

Compound Interest

Simple Interest

Principal invested

₹1,00,000

₹1,00,000

Interest Rate

10%

10%

Investment Tenure (in years)

10

10

Maturity Amount (in Rs)

₹2,59,374

₹2,00,000

Difference in Maturity value (in Rs)

₹59,374

 

At the end of 10 years, investment in a compound interest instrument creates a corpus that is ₹59,374 higher than investment in a simple interest instrument.

In compound interest instrument investment, because of the power of compounding, the interest earned in the previous period was added to interest computation for the next period, thus increasing the effective maturity amount.

Whereas, in the case of investment in a simple interest instrument, interest was calculated on the initial principal for every period only.

How Does Age Play a Role in the Power of Compounding?

Early starters can reach the same goal with less amount of regular savings compared to late starters. Compounding requires time, let us understand this with an example:

A & B started investing in a SIP to create a retirement fund, but for different time periods till they were 60. Both A & B effectively invested the same amount, i.e., a total ₹.7,20,000. The important difference is that A started investing ₹.2000 per month at the age of 30; on the other hand, B started investing ₹.4000 at the age of 45. Assuming the rate of return was 10% for both, let us see how much corpus they accumulated.

power of compounding

As you can notice, even though both invested the same amount of money, A’s corpus is 2.5 times higher compared to that of B! What has worked well for A is the longer investment period, which is double that of B.

This is because a longer investment period extracts more benefits from the compounding effect, which helps generate exponential returns over time.

Power of compounding in SIP

SIP investments are one of the most effective ways of wealth creation that utilize the power of compounding to the fullest.

SIP is a long-term wealth creation instrument that can help to average out your costs and risks. At the same time, the compounding effect may grow your SIP investment multifold in the long term. To put it in other words, SIP and the Power of Compounding work in tandem.

SIP is all about a disciplined investing approach in small, pre-decided installments of money in your selected mutual fund scheme irrespective of market conditions. As per the market condition, the number of units bought every month differs. The power of compounding enhances this benefit, to make the SIP mode of investment a relatively more stable one, in the long term. According to your financial goals, allocate a different SIP to each and let the power of compounding work its magic for you.

To summarize:

To maximize the benefit of compounding in your SIP, do the following-

  1. Start investing at an early age.
  2. Stay invested for a long time.
  3. Keep increasing the SIP contribution.

As a mutual fund investor, the systematic investment plan (SIP) is possibly the best investment strategy for achieving better returns and also your financial goals by encashing on the power of compounding.

Blog Home | Visit our website | Aadhaar Pan Link

Location: India

Comments

Post a Comment

Popular posts from this blog

Basics of Mutual Fund

Image
  Basics of Mutual Fund Do you fully grasp the technical terms used in mutual fund investment? Is the language employed in mutual funds is it difficult for you to understand? Are you unsure of which mutual funds to purchase while searching for them for your upcoming investment? If the answer to above questions is, yes, then let us explain you to in easy-to-understand manner. You may have encountered suggestions to put your money in large- or mid-cap funds rather than small-cap funds. The definitions of "large cap," "mid cap," and "small cap" funds are unclear, nevertheless. How can you differentiate between funds with large-cap, mid-cap, and small-cap? To understand what the word "cap" means, let's start with the basics. What is market cap? Market capitalization is also referred to as market cap. A company's market capitalization is the market value of its outstanding shares. A company's market capitalization is the sum of the market ...
Read more

UNDERSTANDING THE COSTS ASSOCIATED WITH INVESTING IN MUTUAL FUNDS

Image
While investing in a mutual fund, it is crucial for investors to consider the total expense ratio, commonly known as the expense ratio. It is an amount that is hidden from view but directly affects the final returns that are realized. This ratio displays the total costs incurred by a mutual fund plan. Due to their propensity to focus on the returns being created, investors do not usually pay much attention to this figure. The total expense ratio has a significant impact; therefore, it is important to understand how it is calculated as well as how things are evolving in general. Annual percentage figure The total expense ratio provides a general indication of the annual percentage amount that goes into funding operating costs. The costs that are taken into account in the ratio include those related to sales and marketing, advertising, fund management fees, and even other administrative expenditures related to maintaining the fund. A percentage indicates how much of the return actually s...
Read more

CORPORATE FIXED DEPOSITS

Image
 CORPORATE FDs Vs. BANK FDs As is public knowledge, when discussing savings and investing, it is crucial to understand the motivations and feelings of investors. It is challenging for anyone to successfully save money continuously, despite the fact that it is one of the most crucial parts of wealth creation. You may build money and live a quality life while achieving your hopes and goals by setting aside a little portion of your income. A well-planned investment and saving routine can help someone exponentially increase their wealth in a number of different ways. One of them is also referred to as a fixed deposit, the most popular financial instruments in India. As an all-purpose answer for everyone, from saving for a trip to saving for retirement, FDs have long been one of India's most popular investment products. Fixed deposits are currently not the ideal option for long-term goals, despite all the aforementioned investment feelings. However, if the objective is urgent or short-t...
Read more