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What is Power of Compounding and How it enhances your Investments


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January 29, 2019

By : Bajaj Allianz Life

Certain life goals like traveling the world, having a dream wedding, sending the kids abroad for higher education, etc. are very close to our hearts. These goals require careful financial planning. In this scenario, the power of compounding is beneficial. Compounding is an excellent way to ensure a substantial amount to fund your Life Goals. It is a catalyst for generating a considerable corpus over the long term so you can get your Life Goals Done.

The key to successful investment planning is by making the most out of compounding. Therefore, it is essential to understand the basics of the power of compounding. Let us look at how it works.

What is the Power of Compounding?

In simpler terms, compounding is the return earned on the already existing returns on your investment. The money obtained on the returns leads to the growth of funds. The power of compounding is advantageous if you have a long-term investment. Under a ULIP Policy, if you invest a small amount of money regularly, you may receive substantial returns over a long time through the power of compounding.

Let us understand the details with the help of an example of Riya and Priya. Riya makes Rs. 30,000 a month and spends lavishly on clothes, outing, etc. On the other hand, Priya, who also earns Rs. 30,000 per month is a conservative buyer, who saves Rs. 6,000 every month.

  Riya Priya
Monthly Savings in Rs. ` 6,000 ` 6,000
Assumed Rate of Returns (Yearly) 12% 12%
Investment period in years 20 30
Investment value at the end of the tenure ` 59,94,888 ` 2,11,79,483
Difference between Priya and Riya’s Investment Value ` 1,51,84,595

At the end of the investment time period, Riya falls behind in terms of savings by over Rs. 1.5 crore Now how will Riya accumulate the same amount as Priya? In order to catch up with Priya, Riya believes tripling her monthly investments is an excellent solution. Go through the following illustration below, which highlights Riya’s idea:

  Riya Priya
Monthly Savings in Rs. ` 18,000 ` 6,000
Assumed Rate of Returns (Yearly) 12% 12%
Investment period in years 20 30
Investment value at the end of the tenure ` 1,79,84,663 ` 2,11,79,483
Difference between Priya and Riya’s Investment Value ` 31,94,820

Despite tripling her investments, Riya falls short by approximately Rs. 32 Lakhs.

One of the biggest lesson learnt from Riya’s mistake is the significance of time. If Riya had invested at a younger age, she would have definitely reached the same amount of savings as Priya. In simple terms, the benefits of power of compounding is utilized to the fullest when you invest at an early stage of life.

How to enhance your investments?

1. Look for regular investment

As highlighted above, regular investing habit works towards the growth of your corpus provided you start early and stay invested for a long term.

2. Develop a disciplined spending habit

The financial needs of every individual are never-ending. Hence, it is necessary to make smarter investment decisions. Although savings are useful, the investment vehicle ensures the productive use of your hard-earned money.

It is important that you realise the power of compounding at an early age. It is also a great way to build a sizeable emergency fund. Therefore, invest in the right instrument to make the most out of the power of compounding. Always look out for an investment plan which takes in to account your risk appetite and financial goals and thereby helps you achieve your Life Goals.

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