The Power of Compounding Tuesday, August 31, 2010

Compounding in literal term means:-
"The act of combining things to form a new whole"
Now in terms of Investment, Compounding is earning interest on earned Interest.

Prime example of Compounding is the interest earned on Fixed Deposits being added to principal amount periodically till the time of maturity. quaterly,half-yearly or annually.


This is how it works:
Suppose you have Deposited a Sum of  Rs. 100.0 for 3 years with XYZ bank. the bank agrees to pay you an interest of 8.0% half-yearly.Now
at the end of 1st Year the return would be Rs.108.16
at the end of 2nd Year return would be Rs.116.99
at the end of 3rd Year return would be Rs.126.53
so bank will pay you back Rs.126.53 at the end of 3rd year for depositing Rs.100.00

The maths behind this is given by Simple Formula
C.I = Principal(1+Interest Rate)^period
where period is no. of times the C.I is calculated in a year.
based on this period the interest rate varies that why the effective rate of return is always higher than the proposed rate of return.


So we can infer that Money has time value.

The idea behind time value of money is a rupee now is worth more than rupee in the future.
and the relationship between future value(F.V) of money and present value(P.V) can be given by

F.V = P.V(1+r)^t
where again
r = rate of interest
t = no. of years

now lets compare Simple Interest with Compound Interest.
S.I = P.R.T/100
so taking the above example
after 3 yrs the person would get S.I of Rs. 24
so Rs. 100 would be worth Rs.124 after 3 yrs going by simple interest calculation.

The graph shows how much sum of Rs.1000 would fetch you at different rate of Interests over a period of time.
that's the magic of compounding.

From the chart we can come to conclusion that if you give money time to grow it will give back great returns

That brings us to the golden principle of Investing

• Invest Early
• Invest Regularly
• Invest for Long-Term

This power of compounding can be your friend and foe.The same compounding which is used for return of deposits is used by credit card companies to levi charges against you.


So I hope by now we understand how much power of compounding play a vital role in our investment.

"The most powerful force in the universe is compound interest."-Albert Einstein

kindly share your views on above post.