Understanding the Power of Compounding in Investments

Understanding the Power of Compounding in Investments

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Jaya
Jaya Sharma
Senior Executive Content
Updated on Feb 1, 2024 17:56 IST

Compounding is applied whenever you want to multiply your returns on investments. Through compounding, investors gain interest over interest.

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Compounding is an important concept in investing. Once you learn about it, you will no longer work for money. Instead, money will work for you. It is the process of reinventing capital gains and interest to generate additional earnings over time. The growth is exponential since the investment generates from the principal amount and accumulated earnings from the previous periods. In this article on the power of compounding, you will learn about the impact and future values of investing.

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Table of Contents

“Compounding is the interest on the interest that magnifies returns to interest over a period of time.”

Concept of Compounding

Let us understand this concept through a simple example. 

  1. Suppose the rate of interest is 5% on the principal amount which is 10,000 rupees. This means that at the end of the period, the total amount will be 10,500 (principal + interest). 
  2. In the next phase, you will get the interest on the principal and the previous term’s interest.
  3. This means that you will get the interest on 10,500 at a 5% interest rate which will be equal to 525 rupees.
  4. Now the total amount will be 11,025 rupees. 
  5. After 10 years, this amount will be equal to 16,288.95 rupees. 

An example of compounding is dividends. Dividends also work on the concept of compounding. Many companies offer dividend reinvestment plans in which investors can reinvest their cash dividends for purchasing additional shares of stock. This reinvesting compounds the returns since the increased number of shares will further increase the future income from dividend payouts. 

Is compounding a good investment method?

“Compounding is one of best investment methods, that reaps exponential amounts as compounding period increases”

Future Value On An Investment Through Compounding

Compounding has an exponential effect on the investment, which can be seen in a certain period of time. This amount will be the future value which is the expected value of an investment at a future date based on the assumed rate of growth. This is calculated using the present value which is the current value of the investment.

Here:

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    • FV=Future value
    • PV=Present value
    • i=Annual interest rate
    • n=Number of compounding periods every year (cycles)

For example, the principal amount is 1,000 dollars. Now, we will calculate the amount after a period of 20 cycles to find out the future value. 

  1. Here, the start principal will include the periodic deposit i.e. $ 100 in every cycle. i.e.10000+(10000*5)/100 = 10,500. 
  2. In the first cycle, the start principal was $ 1,100.
  3. In the second cycle, the start principal included $100 more. Now, the start principal will be $ 1,200 and so on.
  4. Start balance will be the sum of start principal and interest for the previous cycle. 
  5. If the start balance was $1,200 for the second cycle and the interest for the first cycle was $55 (the rate of interest is 5%), then the start balance will be $1,2 55 ($1,200 + $55). 

Future Value Over 20 Cycles

Let us see the future value after 20 cycles.

Compounding Period Start principal Start balance Interest Future Value
1 $1,100.00 $1,100.00 $55.00 $1,155.00
2 $1,200.00 $1,255.00 $62.75 $1,317.75
3 $1,300.00 $1,417.75 $70.89 $1,488.64
4 $1,400.00 $1,588.64 $79.43 $1,668.07
5 $1,500.00 $1,768.07 $88.40 $1,856.47
6 $1,600.00 $1,956.47 $97.82 $2,054.30
7 $1,700.00 $2,154.30 $107.71 $2,262.01
8 $1,800.00 $2,362.01 $118.10 $2,480.11
9 $1,900.00 $2,580.11 $129.01 $2,709.12
10 $2,000.00 $2,809.12 $140.46 $2,949.57
11 $2,100.00 $3,049.57 $152.48 $3,202.05
12 $2,200.00 $3,302.05 $165.10 $3,467.15
13 $2,300.00 $3,567.15 $178.36 $3,745.51
14 $2,400.00 $3,845.51 $192.28 $4,037.79
15 $2,500.00 $4,137.79 $206.89 $4,344.68
16 $2,600.00 $4,444.68 $222.23 $4,666.91
17 $2,700.00 $4,766.91 $238.35 $5,005.26
18 $2,800.00 $5,105.26 $255.26 $5,360.52
19 $2,900.00 $5,460.52 $273.03 $5,733.55
20 $3,000.00 $5,833.55 $291.68 $6,125.22

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Power of Compounding: Its Impact

Now, let us see the impact of compounding through the following graph:

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As you can see from the above graph, in 20 cycles, the amount compounded to $ 6,125.22 (future value). If we go into details, we can see that the start principal was only $1,000 which is 16.3% of the total amount, the periodic deposits were $2000 i.e. 32.7%. The total investment yielded  $ 6,125.22 which is a whopping 51% interest.

Why is Compounding Important?

The effect of compounding strengthens with the number of compounding periods. This means that the future value of an investment will increase with cycles. Your money grows much faster through compounding in comparison with simple interest. This happens because you get the interest on the principal as well as interest from the previous cycle. Whereas in simple interest, you only get an interest on the principal amount. 

Conclusion

We hope that you have now understood the power of compounding. You might not see its results in the beginning during a few cycles. As the time of investment progresses, and compounding cycles increase, you will see a huge spike in returns on investment. It is important to maintain consistency in investments and remain patient for the time being. 

FAQs

Does investment in stocks compound?

No, it does not occur in stocks but it is possible in mutual funds.

Which investments are compounded on a daily basis?

Amounts in a savings account are compounded on daily basis.

Which is better between daily and monthly compounding?

Yes, daily compounding is better than monthly compounding since more frequency of compounding gives better results.

Is the interest on IRS compounded daily?

The rate for IRS is set every month and is compounded on daily basis. You will have interest on the unpaid tax from the due date of return till the payment date.

About the Author
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Jaya Sharma
Senior Executive Content

Jaya is a writer with an experience of over 5 years in content creation and marketing. Her writing style is versatile since she likes to write as per the requirement of the domain. She has worked on Technology, Fina... Read Full Bio

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