Compounding Effect: The Money Quadrupling Magic

Do you know what the quickest path to towering wealth is? One plausible way is to discover a treasure map hidden in your great grandfather’s old closet. Far fetched but a perfectly reasonable way. However, it might take you a long time to find that treasure, if at all–10 years maybe. Who knows?

Here’s another problem with that: What if the treasure you finally find is equal to what you spent to see it in the first place? That would be a bummer.

Had only you read this blog and decided to invest, those savings would have quadrupled in those ten years. We at Spenny sometimes think that we do god’s work, you know? Convincing people to invest the capital they would have spent on the treasure hunt.

Anyways, let’s unravel the money quadrupling magic humans call Compounding.

What is Compounding?

Whenever we invest our money and get some returns on it, those returns also factor in the new capital. When you look at the oh so familiar compound interest formula, you see a small ‘t’ at the top. Do you know what that stands for? TIME. Time is what brings out the true power of Compounding: exponential growth. Let’s dive deeper:

Suppose you invest Rs.100 into a Mutual Fund that promises a 10% return. After a year, you will have Rs 110, and this becomes your capital for Year 2, so now the returns will be calculated on Rs 110. Thus you will have Rs 121, and the cycle continues.

In the long run, this phenomenon will increase your wealth multifold. A mere Rs.500 investment every month for 20 years yields about 5 Lakh rupees, even though the capital you invest is just near a lakh. The key is just to sit tight.

The math is elegant, but the implications of this math are brilliant, you know?

Say you put 1 Lakh rupees in a mutual fund that gives you 15% returns annually. Since this interest compounds every year, returns skyrocket towards the later period. The same 1 Lakh rupee is:

• In Year 5: 2.01 Lakhs
• In Year 10: 4.04 Lakhs
• In Year 15: 8.13 Lakhs
• And In Year 20: 16.36 Lakhs

Digest this; from Year 5 to Year 20, you have already multiplied your capital by more than eight times. If you start investing early on, compared to investing at a later age, your returns will be significantly higher.

Compounding is, of course, affected by some parameters.

Parameters that Affect Compounding

• Returns: The profits you earn on your investment. We assumed this to be 10-15% in all the examples above, but in reality, the returns depend on the asset class. For instance,
• Fixed Deposits: 4-6%
• Debt Mutual Funds: 7-10%
• Equity Mutual Funds: 11-15%
• Stocks: Can be negative or 200%. Depends on your picks.
• Time Duration: This impacts compounding the most. Exponential growth only happens if you stay put. Your money is quite literally the Chinese Bamboo: “it won’t grow for the first four years, but it will shoot up to 80 feet in the fifth year.”
• Tax Rates: Your returns are taxed only at the time of withdrawal.

How does Compounding work in different Asset Classes?

Now that we understand this powerful tool, it’s essential to check how it works for different asset classes:

• FDs: In fixed deposits, since there is a specific lock-in period, if you do not withdraw your money regularly, the interest that your earn also earns for you.
• Mutual Funds: These funds have GROWTH written next to them. This works because all the profits are invested back into the fund, thereby increasing the capital and ultimately returns.

Conclusion

• Start Early. Compounding is a highly effective but long-term game.
• Discipline is crucial. Your financial goals should be intact, and you should keep investing no matter what.
• Finally, be patient. Investing is a marathon, not a sprint: a cliched statement, but the truthful one.

We at Spenny solve this for you, you know? We make investing automated so that you can reap the benefits of Compounding with minimal effort. We hope this blog convinced you to start investing as soon as possible. See you in the next one!

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