The world of finance and investment can prove to be a place of alchemy with the right approach and assets, where the compounding effect transforms your investments into a magical pot of gold. When you understand how earning interest on your already earned interest can exponentially increase your wealth over time, you can draft a robust plan for your investment journey.
Among various options, mutual fund investments are popular for offering compounding gains through the same principal over time. In this blog, we will unravel the effect of compounding and explore some real-life examples that show its incredible impact on investments.
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The magic of compounding – The fable
In the 8th century, an ancient Indian mathematician named Brahmagupta pondered the magic of compounding. Little did he know that his musings would lay the foundation for an investment principle that transcends time. Compounding, the snowball effect of earning interest on both the principal and accumulated interest, is the secret that turns modest investments into substantial wealth over time.
Consider the tale of Akbar and Birbal. In this popular fable, Akbar challenges Birbal to present a reward for his exceptional wit. Birbal, being the financial sage, proposes a unique reward – he asks the king to place one grain of wheat on the first square of a chessboard and then double the amount on each subsequent square. Akbar, intrigued but unaware of the power of compounding, agrees.
As the story unfolds, the king soon realizes the staggering impact of compounding. By the time he reaches the 64th square, the grains of wheat have multiplied to an astronomical sum, surpassing the kingdom’s entire wealth. This parable vividly illustrates the exponential growth that compounding can achieve.
Understanding the compounding effect in Investments, with an Example
Now, let’s translate this magic to the realm of investments. Imagine you invest ₹1,00,000 in a mutual fund aligning your financial objective and earning an average annual return of 12%. Using a compound interest calculator, we can unveil the mesmerizing growth over time.
Table: Growth of ₹1,00,000 Investment Over 20 Years
| Year | Investment Value |
|---|---|
| 1 | ₹1,12,000 |
| 5 | ₹1,76,234.24 |
| 10 | ₹3,10,585.22 |
| 15 | ₹5,47,715.76 |
| 20 | ₹9,65,106.45 |
This table illustrates the compounding effect over two decades. Notice how the growth becomes more pronounced as time elapses. The initial investment grows into a substantial sum, showing the effect of compounding in building wealth.
How to maximize the benefits of compounding
- Start early: Time is among the most detrimental factors in delivering the power of compounding. The earlier you begin, the more magical the results. Even small amounts invested consistently over a long period can lead to significant wealth accumulation.
- Reinvest earnings: Allow your earnings to accumulate or keep reinvesting over time to enjoy a better compounding effect. Instead of withdrawing dividends or interest, reinvest them to magnify the compounding effect.
- Choose the right investment vehicle: Opt for the best mutual funds with a proven track record. Diversified portfolios and professional fund management enhance the likelihood of consistent returns.
- Be patient: You need patience to witness the power of compounding. Avoid disturbing your investments frequently and let time weave its compounding magic.
Conclusion
In the world of investment, the effect of compounding proves to be the golden thread that weaves financial success. With the knowledge of compounding and guided by strategic choices, your investments can grow substantially over the period.
