The Power of Compound Interest in Stock Market Investments

Compound interest is often called the eighth wonder of the world, and for good reason. With compounding, you earn returns not just on the original amount you invested, but also on the returns it has already generated. Over time, this creates a snowball effect that can lead to impressive growth.

Let’s dive deeper to understand the power of compounding in the stock market investments to help you achieve your financial goals.

What Is the Power of Compounding?

The power of compounding lies in its ability to grow your wealth by reinvesting the returns earned over time. It adds the interest earned on the principal amount in the previous periods to calculate the interest for the current and following periods. This creates the chain reaction of generating profits on the interest earned as long as your funds remain invested, helping you achieve your long-term financial goals. 

The earlier you start and the more consistent you are, the better the returns. This makes compounding one of the most effective tools for achieving long-term financial goals.

Power of Compounding in Mutual Funds

Mutual fund investments can accelerate your financial growth through the power of compounding. You can invest either by making a one-time lump sum payment or by opting for regular contributions via a Systematic Investment Plan (SIP). However, the second option gives you the advantage of compounding at a fraction of the investment cost. 

Using SIPs, you can invest in your chosen fund by making regular deposits (monthly, quarterly, or annually). Profits earned on the investment are then reinvested back into the mutual funds, giving you the benefit of the power of the compounding effect. In the long run, this effect of compounding will grow your investment amount significantly. 

Let’s understand the power of compounding in mutual funds when investment is done through SIPs.

Suppose you started an SIP of ₹10,000 per month in an equity mutual fund, with returns being 12% annually. After 10 years, the investment would amount to approximately ₹23 lakhs, which includes your invested amount of ₹12 lakhs over 10 years. If, instead, you had earned simple interest and not reinvested the gains, the value would have been significantly lower, around ₹21 lakhs or even less, showing a major difference in returns generated. 

Investors can benefit from the compounding effect through regular investments using SIPs. With a disciplined approach, SIPs can generate great returns to help you meet your investment objectives.

Formula for Compounding

The following formula is used for compound interest calculation:

A:  P(1 + r/n)^(nt) 

Where:

• A: final amount
• P: principal amount 
• r: the annual interest rate
• n: number of times the interest is applied per time period
• t: number of time periods elapsed

Example of Compounding

For example, let’s say a person called ABC invested ₹2,00,000 for five years at 10% p.a. returns.

Scenario 1: Interest earned will be withdrawn every year. At the end of five years, ABC will end up earning an interest of ₹1,00,000.

Scenario 2: The interest is added back to the initial principal amount every year. At the end of five years, ABC will end up earning an interest of ₹1,22,102.

In the second case, you can see the power of compounding, multiplying your invested funds.

What are the Advantages of Compound Interest?

Compound interest offers you multiple benefits to help you grow your financial position tremendously in the long run. Here are some of them:

• Accelerated Growth Over Time: By continuously reinvesting returns, your investment grows faster, as both your initial amount and the earnings start generating additional returns.
• Inflation Protection: Higher compounding returns can help your savings grow faster than inflation, preserving your investment’s real value.
• Easier Financial Planning: Compounding makes it easier to reach savings goals without needing to contribute large sums regularly.
• Surplus Creation: Often, compounding leads to accumulating more than your target, giving you a financial buffer for future uncertainties.
• Stress-Free Wealth Building: With time and consistency, compounding allows you to grow wealth steadily without the need for active or risky investment strategies.

Key Rules of Investment that Enable the Power of Compounding

By following the rules mentioned below, investors can make the most out of the power of compounding:

• Start Early: Starting to invest early can give an edge as it enables you to grow your funds.

• Long-term Investment: To fully benefit from the power of compounding, you should invest for the long term.

• Regular Investment: Investing funds in regular intervals, like monthly, quarterly, or yearly automatic investments, gives you an edge. Just make sure that investments are done consistently.

• Diversify your Investments: Make sure you diversify your portfolio by investing in different securities and sectors to reduce risks and improve returns.

• Invest in Growth-Oriented Securities: You should make investments in assets that have high return potential to let compounding work for you.

• Avoid Additional Charges: Pick low-cost investments to avoid additional charges, as they can significantly eat into your profits and diminish the power of compounding.

Conclusion

Compounding helps your investments grow faster over time. When you reinvest the interest or profit you earn, it starts earning more too. This creates a chain reaction, and your wealth grows more and more as time goes on. To make the most of compounding, set clear long-term goals, stay patient, and keep investing regularly.

If you want to start your investment journey, open a 3-in-1 account with Torus Digital today!