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This is how compounding works

Compounding returns, especially in growth assets like equity can help you create wealth provided you give it enough time and hence, start early.

If there was one slogan that mutual fund advisors should adopt and investors should follow blindly, it has to be – Start Early. Starting early gains emphasis thanks to the benefits of something called compounding returns.  Compounding returns, especially in growth assets like equity can help you create wealth provided you give it enough time and hence, start early. 

What is compounding?

In simple terms it is the piling of value on top of value. For investments, this translates to gains made on existing gains along with principal. Let’s say you have put money in a deposit scheme that gives you fixed interest. A 6% annual interest on a Rs 1000 deposit results in Rs 60 pay out. If it is simple interest, your account will be credited with Rs 60 every year till the deposit continues. On the other hand, if it is compound interest, from the second year onwards, you will earn 6% on the previous year’s interest pay out too (along with principal). Hence, your year two interest will be Rs 63.6. Compounding interest, increases return. 

Now, think about a market linked investment in equity, where the pay off is not defined. Let’s say you invested in a share of ACB Ltd, at a price of Rs 1000. The stock gains 12% in a year, thanks to favourable earnings; your stock price is Rs 1012. The company continues to do well, the price goes up 15% in year 2, 10% in year 3 and 4 each and 11% in year 5. The return you earned in the previous year will compound with the current year’s gains. At the end of five years, your Rs 1000 will be Rs 1730 or a gain of 73%. This exponential growth in your investment is always a more desirable path as compared to the simple return.

This is the magic of compounding, the growth in the capital value by reinvesting the earnings from an investment back into the investment itself.

Unlike the example used above, compounding in equity rarely happens in a straight line. Equity returns will move up and down, you have to remain invested for a minimum of 7-10 years to see the potential of equity compounding. 

Caveats

It does sound like magic to get exponential return, but, don’t ignore risks. Here are things you need to be mindful about when it comes to compounding returns in equity investments. 

1. Compounding works best over a long period. This is where the merit of starting early plays a role. At 10% per annum, Rs 1000 compounds to Rs 6,727 in 20 years and it compounds to Rs 17,450 in 30 years. This enhancement of returns cannot be ignored.

2. Unlike the example used above, compounding in equity rarely happens in a straight line. Equity returns will move up and down, you have to remain invested for a minimum of 7-10 years to see the potential of equity compounding. 

3. Just as gains compound, losses compound too. The pace of downward compounding can seem much faster too. What this means is that just as you can gain exponentially in equity, you can lose value too. Hence, there is no substitute for good selection. Pay attention to quality of your investment.

What is important is to focus on the benefits of compounding, pay attention to quality and start early for compounding to result in wealth creation. 

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