The Power of Compounding in Long-term Investments

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Equirus Wealth

13 Jan 2023 5 min read

Investment#Investment#Finance

The power of compounding in long-term investments:

Many great investors have sung the virtues of long-term investing. Take Warren Buffet, for instance. He said, ‘Successful investing takes time, discipline, and patience. You can't produce a baby in one month by getting nine women pregnant. He had also commented, ‘Time is the friend of the wonderful company, the enemy of the mediocre’.

Both quotes stress the importance of time. If you give your investments time to grow, you will be surprised at the corpus you can accumulate.

Wondering how time influences your investments?

The answer is one magical word – compounding.

The power of compounding works miracles on your investments and allows your corpus to grow exponentially. Let’s understand.

What is compounding?

Compounding is a mode of accumulating returns wherein you earn returns on the past returns already earned. In simpler words, when you invest a sum of money, the returns that you earn get added to the investment amount and increase its size. Thereafter, subsequent returns are calculated on the accumulated amount. This way, the returns multiply since you earn returns on the returns previously earned.

Let’s understand with an example.

Say, you invest Rs.1 lakh in an avenue that delivers 10% annual returns. You choose an investment tenure of 5 years. Now, let’s see how compounding will work its miracle –

PeriodInvested amountInterest rateInterest earnedTotal amount
Year 1Rs.1 lakh10%Rs.10,000Rs.110,000
Year 2Rs.110,00010%Rs.11,000Rs.121,000
Year 3Rs.121,00010%Rs.12,100Rs.133,100
Year 4Rs.133,10010%Rs.13,310Rs.146,410
Year 5Rs.146,41010%Rs.14,641Rs.161,050

Thus, after 5 years your corpus grows to Rs.1.61 lakhs, i.e. more than 150% because you earned returns on the previous returns. This is how compounding works.

Compounding and the time factor

The true miracle of compounding can be observed if you give your investment time. Take the above example itself. If five years enhanced the corpus by more than 150%, what would 20 or 30 years do? Imagine the exponential returns that you can earn.

The reason why financial experts recommend long-term investment is for compounding to work its magic. If you adopt a disciplined investment approach and give your investment time, you can amass a considerable corpus for your financial goals even with humble savings.

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The following example will drive home the importance of time in compounding –

Case 1Case 2
Investment amount – Rs.10,000 per monthInvestment amount – Rs.10,000 per month
Interest rate – 10% per annumInterest rate – 10% per annum
Investment tenure – 20 yearsInvestment tenure – 30 years
Corpus – Rs.75.93 lakhsRs.2.26 crores

As you can see, there’s only a difference of 10 years in investment tenure and the corpus is reduced considerably (more than twice). This is how the long-term horizon gives the best results through the power of compounding.

Now, add another 5 years to the investment tenure and make it 35 years. The corpus will increase to Rs.3.79 crores! Just 5 years and such a considerable difference!

Maximizing the time factor

Since long-term investing is rewarding, you need to maximize your investment horizon so that you can accumulate a sizeable corpus for your goals. One of the ways to do so is to start young. When you start saving at a younger age, you will have time on your hands before you need funds for your financial goals. For instance, say you start saving at 20 or 25 years of age. If you get married at 30 and have a child by 33 years of age, you will have enough time on your hands to create a corpus for your child’s higher education.

Similarly, when planning for retirement, you should start saving early. As you will retire in your older years, your savings will get time to accumulate and grow with the power of compounding. This will give you an optimal retirement corpus so that you can live out your golden years comfortably.

Besides starting young, stay disciplined. Do not dip into your savings unnecessarily. Let your savings grow and accumulate into the corpus that you have envisaged.

The bottom line:

Compounding is a wonderful tool that helps your investments grow and accumulate into a considerable corpus. The power of compounding can be observed in long-term investments, so you should not hurry with your investments. Have patience and watch your corpus grow with time. Stay disciplined and save with a long-term perspective so that you can achieve your goals and gain financial freedom.

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