Power of compounding

By definition compounding is the process of generating earnings on earnings. i.e. the initial earnings are reinvested to generate more earnings. As you are aware, for any earning there have to be two things Asset and time. For compounding you need to have two things that is time and initial earnings. So it means that the initial earnings have to be reinvested and over a period of time it will generate more earnings.

So let us take an example, if you invest Rs. 1 lakh for a 10% return over a year, at the end of the year, you would get Rs. 1,10,000/- in this the earning is Rs.10,000/- , the Asset is Rs. 1 lakh and time is one year. For Compounding, this initial earning of Rs. 10,000/- has to be reinvested over time. Assuming the same one year time frame and 10% return, you would get Rs. 1,000/- over a year. Don’t forget that you would keep getting the Rs.10,000 over the initial Rs. 1 lakh as well. In this way, Rs.1 Lakh invested over 15 years at 10% return could get you Rs. 4,17,725/-.

Compounding fuels growth of your money, so why let it lie idle in a savings bank account, when it could fetch more. You could put it in a fixed deposit at the same bank and generate 8 to 9 % or in a company fixed deposit or debt mutual fund for 9 to 10%. But remember in fixed deposits the interest generated is taxable. There are better ways to earn your income and still save tax. If you are ready to keep your funds for 3 to 5 years debt mutual funds are the best, as the return would be capital gains and the tax after taking indexation into account would be negligible.

Always remember the longer the period and higher the return percentage, the better the compounding. If you are ready to wait for 10 years, the best option would be to go for equity mutual funds, historically they have generated a return of around 15 to 16% returns, that too tax free. Invest with a plan in hand and watch the power of compounding.