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Want to Grow Your Wealth Exponentially? – Understanding the Magic of ‘Compounding’

Last Updated : 22 Sep, 2023
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One of the most talked-about topics in investing is the magic of compounding. Many wonders if it is possible to get an extra return on their investment by investing in terms of compounding. The answer is a simple yes and no. Yes, it is possible to get an excess return on your investment by investing in terms of compounding.

While it may seem like a simple concept, compound interest is one of the most powerful tools in finance. It can grow your money much faster than you think. Over time, this will result in more money. Unfortunately, this isn’t something that everybody understands.

Understanding the Magic of Compounding:

The magic of compounding is a term used in finance to describe the phenomenon where small returns on a single investment become much larger returns over a period of time due to the ability to reinvest those returns and earn more interest. Over the long term, this can significantly increase the return an investor gets on their investment i.e., enabling them to achieve much more significant returns on their money than would have been possible if they only invested a small amount initially.

This is one of the primary reasons why many high-net-worth individuals and companies choose the path of compounding, as it enables them to achieve much higher returns on their money than they would have been able to otherwise.

Investing- A Numbers Game:

You need to have a clear idea of your goals and risks and then find the investment vehicle that is best suited for you. There are several different tools at your disposal when it comes to investing, some are better for long-term goals, and others are better for short-term goals.

Compounding is the magic in terms of investing, where your money grows at an exponential rate. Thanks to compounding, people can retire early, invest their money, and double their invested amount.

Let us see an example of how compounding actually works:

1. Suppose you have invested Rs 50000 at an interest rate of 10%.
2. In the first year, you'll earn an interest of Rs 5000 (interest at 10% of 50000). But in the second year, you'll earn an interest of 10% on the original investment of Rs 50000, which is equal to Rs 5000; along with it, you'll also gain the interest of 10% on the previous earned money of Rs 5000, i.e., Rs 500 (10% of 5000). Hence, in the second year, you'll make a total of Rs (5000 + 500), i.e., Rs 5500.

3. In the third year, you'll earn 10% of 50000, i.e., Rs 5000, and 10% on the interest earned in previous years, i.e., 10% of Rs (5000 + 5500) equal to Rs 1050. Hence, in the third year, you will earn Rs 6050. 

As you can see, there will be guaranteed growth in your investment year by year. To simplify, compounding makes you earn money on both the interest accumulated in the previous period and the capital invested. No wonder why compounding is termed the eighth wonder of the world.

Ways of Compounding:

  1. One can buy the equities of a company. If you have the right amount of money, you can invest in a startup by purchasing some of their equities. Once the startup succeeds and slowly becomes a brand in its industry, your investment will give you crazy returns. But like any other investment, keep in mind that this is a long-term game. 
  2. Stocks are one of the most efficient ways of gaining more than 10x returns in the long term. Ensure that you do a proper analysis of the key metrics and the right research on the industry and management.
  3. The rise of cryptos has paved the path for several crypto enthusiasts to invest in the world of cryptocurrency, metaverse, and NFTs. Keep in mind that the crypto market is too volatile, and you may lose all your money. 
  4. You may start investing in mutual funds via SIP to reap the benefits of compounding. SIPs can begin at 500 INR, thus making it easier for the masses and college students. As a matter of fact, investing from your early days has its benefits.

Point To Keep in Mind Before Investing:

  1. The first thing to remember is that you do not want to invest in stocks that will lose money. Analyze the risk-reward ratio and properly research quality stocks. You may invest in blue-chip firms and mid and small-cap firms where you see a good future potential. 
  2. The next thing is about diversifying your portfolio. SIPs are great too, and so are REITs. Don’t invest too much in one stock, increasing your risk factor. 
  3. Before you start investing, you need to make sure that you know the risks involved. You should also know how much money you want to invest, your goals, and your risk tolerance. 
  4. Make sure that you are investing in something that has a long-term future. If your stock market is in a bubble, you are better off buying a house or a business and earning a high return. 
  5. You must have patience; earning through compounding is definitely a time taking process. It takes years to give you a high return, so patience is the key to success in this field as empires do not build in a single day. 

Final Words

After going through this section, you might have specific ideas about investing w.r.t. compounding. It is clear that this is not a fraud or trap-making scheme; you won’t be a millionaire in a day as the magic of compounding lies in time. Just have patience and wait for the time when you will earn the compound interest of your invested amount. 

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