What is compounding?
Compounding typically refers to the increasing value of an asset due to the interest earned on both a principal and accumulated interest. It has made use of the Time Value Concept of money to derive the compound interest.
Magic of compounding
There is a famous story of a king who lost a game of chess against a wise man who tricked the ruler into giving up his kingdom. He was liable to pay the winner anything he demanded. The wise man replied that he wanted grains of rice to be put on the chessboard in a particular manner. The first square of the board would have one grain, the next square two, the third square four, the fourth square eight, and so on. Therefore, for every successive square on the chessboard, the amount of rice would have to be doubled. The king laughed and granted his wish thinking that it is one of the simplest demands ever made by a winner. But soon the king’s treasurer informed him that a million grains of rice would have to be paid by the 20th square, a billion grains by the 40th square and 18 quintillion grains by the last square. There were not enough grains in the entire kingdom for this kind of award. The king was as surprised by the nature of compound interest and decided to use it to increase his treasury.
How to make the most of compounding?
Compound interest is perhaps the smartest strategy one can use to exponentially grow his wealth. The name of the game with compound interest is time, and the more of it you have, the bigger the payoff. This can be verified from the example given below:
Person A invested Rs 1,00,000 in 2005 at an annual interest rate of 6% and invested 50,000 into the account every year. His account will be worth Rs 1923171 (2023).
Person B invested Rs 1,00,000 in 2008 at an annual interest of 6% and invested 50,000 into the account every year. His account will be worth Rs 1473085.
There will be a difference of Rs 3,00,011 in compound interest alone. Compound interest is perfect for long term investors but there are better places to invest short term which give higher rates of return.
Mutual Funds
A mutual fund is a financial vehicle that pools assets from shareholders to invest in securities like stocks, bonds, money market instruments, and other assets. They are headed by a fund manager who needs to work in the best interest of the shareholders. They function in a similar manner to shares of a company and give returns in the form of dividends and/or increased prices. A mutual fund has annual operating/shareholder fees which ranges from 1-3%.
The pros of mutual funds entail diversification and liquidity of funds. They are easily accessible and operated on by professionals ensuring maximum return for one’s investments. Investors have the freedom to research and select from managers with a variety of styles and management goals. Mutual funds are subject to industry regulations and thus provide transparency at all stages.
The cons of mutual funds include no guarantee and high fees for the professional management. They are subject to market prices and are a high- risk high- reward investment.
Bottom line
One can take advantage of the magic of compounding by investing regularly and increasing the frequency of loan repayments. It has the power to increase money at a much faster rate than simple interest and is a central factor of increasing wealth. Compounding can mitigate the cost of living caused by rising inflation and offers a great opportunity to the young investors of the world. The bottom line is that choosing the compounding periods is just as important as choosing the interest rate.