As a novice investor looking to grow wealth, understanding compounding can be one of the best things you can do in order to start your investment journey on a positive note. This is because harnessing the power of compounding can help you grow your wealth exponentially.
Compounding is a process during which an asset’s earnings are re-invested in order to earn more. This growth is quite substantial because the sum you invest gains earnings based on the initial amount that was invested, as well as the accumulated earnings that you gain from the preceding investments. Compounded is calculated with the help of exponential functions and is, therefore, not a form of investment that offers linear growth. Thus, instead of earning a fixed interest over a period, your investment earns double the amount (figuratively) than it would if you had not harnessed the power of compounding. In this article, we will discuss more about how you can increase your wealth through compounding.
Why is compounding great for investors?
Compounding is an exemplification of the concept of Time Value of Money (TVM). According to this, the value of money at any given point in time is always worth far more than its identical amount in the future. In other words, $ 50 today is worth far more than the same amount of money 10 years down the line.
Investing vs Setting Aside Funds:
One of the biggest advantages of compounding your money is that you can beat inflation and ensure that the lump sum you earn in the future actually has the value that you once hoped it had. Consider this: say you want to buy a home for $ 60,000. You break down your monthly budget, eliminate extraneous spending, and realise that you can set aside $500 every month. This means that if you set aside $ 500 for 10 years, you will be ready to buy your dream home. However, lets say the rate of inflation in your country is 7% per annum. This means that the house you want to buy will be worth $ 1,02,000.
Investing in Funds that Offer Compounding vs Investing in Funds that Don’t:
When you invest in funds that do not offer compounding, you can still enjoy a steady linear growth. Investing $ 10,000 per annum in a fund that offers 10% growth for 10 years will help you grow your funds to $ 1,10,000. This is because the growth that you earn only applies to your principal amount. However, if you choose compounding, then you earn not only on your principal amount, but also on the amount that you have earned that year. As a result, your final lump sum is much larger than what you would receive from a fund that offers only linear growth.
How Compounding Helps
If you choose to invest $ 10,000 in a fund that also uses compounding, you will earn far more. For the sake of this illustration, let’s say the fund earns 5% per annum. During the first year your total sum of $ 10,000 will grow to $10,500. However, during the second year, you will earn interest on both, the principal amount and the new earnings, which will be an addition of $ 525, making the total $ 11,025. After 10 years, this amount will grow to $ 16, 288.95
Compounding is the Basis for Future Value
The formula that is used to calculate compound interest is FV = PV x [1 + (i / n)] (n x t)
In this, the following values are used to calculate the compound interest:
FV = future value
PV = present value
n = the number of compounding periods per year
i = the annual interest rate
t = the number of years
Compounding is one of the most important parts of investments, and funds that offer compounding are generally more sought-after than the funds that do not. A very common form of an investment product that uses compounding are dividend investment plans that are offered by various companies. Through these plans, companies allow their investors to reinvest the cash dividends that they have earned in order to buy more shares of stock. These helps investors compound their returns because higher number of shares they have will contribute to consistent earnings in the future through dividend payouts. If an investor chooses to invest dividend growth stocks as well as dividends, they can enjoy the joys of double compounding. This significantly increases their per-share payouts.
The Key to Success is Starting Early
As you may have noticed by now, time plays a crucial role in investments, particularly in compounding. Therefore, the sooner that you start, the more growth you can expect with lower premiums.
Let’s say that you are in your 20s and you want to earn $ 1,000,000 by the time you hit 60 years of age. The fund you have considered offers a growth rate of 5%. Thus, in order to meet your goal, you must invest approximately $ 880 every month. Of course, in this example, we are assuming that the fund performs well and offers you the growth promised each year.
Now, let’s say that you are in your 30s and you wish to meet the same goal. In spite of compounding, you need to invest approximately $ 1,680 every month. Similarly, if you are in your 40s, then you must invest $ 3,741 every month. Though your end goal is the same, your premium rates increase quite a bit as you grow older. Therefore, it is always more beneficial to start your investment journey at an earlier age in order to reap the rewards you want without having to compromise too much on your monthly budget.
Compounding is one of the best ways to grow your wealth as it offers such high returns. Before doing so, you must understand a few basics such as risk profiling, which we’ve highlighted in our previous article about starting your investment journey.