The power to make financial investment worse


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To truly reap the benefits of compounding, you need to stay invested for the long term.

In the world of finance, an oft-repeated and widely revered word is composition. Nicknamed by Albert Einstein as the 8e wonder of the world, the magic of compounding is that it can help investors multiply their returns over the long term.

In the case of interest or simple returns, investors get a fixed return on the capital initially invested.

For example: If you invest Rs 100 for 5 years at an interest rate of 8% pa., You will earn interest of Rs 8 each year and at the end of the 5the year you will receive Rs 100 (the principal) plus Rs 40 (interest earned) bringing the total value of your initial investment to Rs 140.

In the case of compounding, not only will you earn interest on the initial principal, but also on the interest you earn each year.

For example: If you invest RS 100 for 5 years at 8% interest rate, compounded annually, you will earn Rs 8 interest in the first year. However, in the second year you will earn 8% on the principal amount of Rs 100 and also 8% on the Rs 8 earned in interest in the first year. At the end of the fifth year, the total value of your investment would be Rs 146.93, which is Rs 6.93 more than what you earned in simple interest.

Table I – The effect of composition

The compound effect works exceptionally well over the long term. The overall benefits of compounding are influenced by the time horizon of the investment and the rate of return. It is also impacted by the frequency of the composition, ie. monthly, quarterly or annually.

Table II – Impact of time horizon and rate of return on composition

To truly reap the benefits of compounding, you need to stay invested for the long term.

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