SIP and the Magic of Compounding

by Vinaya HS on October 11, 2017

in Finance

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The first rule of investing is to start now irrespective of your age. A disciplined investor is able to earn higher returns and build more wealth through the power of compounding.

About compounding
Compounding originates from the term compound interest. Compound interest arises when your interest earnings are added to the principal amount. This allows your interest earnings to earn additional returns. The addition of the interest earnings to the principal amount is known as compounding. You may use an online calculator to estimate and understand your returns through the magic of compounding.

Benefit of compounding

One of the biggest benefits of compounding is that you may be able to accrue high returns over a little period of time. This is because with compounding, your returns also earn returns and this continues until you stay invested. This enables you to accumulate huge profits at a fast pace. However, you must follow a disciplined approach and continue making regular investments to enjoy the benefit of compounding.

When you do not withdraw your earnings from investments and reinvest these, over a period, you are able to generate higher returns. Through compounding, your investments have the capability to become an efficient income-generating asset.

Understanding the power of compounding

Let us use an example to understand the power of compounding. Assume that you invest INR 50,000 in a financial product that offers a 10% annual return. You opt to reinvest the interest, which is added to your initial investment amount. Here is how your money will grow over a period of 20 years.

Interest earned in the first year would be INR 5,000 (10% on INR 50,000)

Principal amount in the second year would be INR 55,000 (50,000+5,000)

Interest earned in the second year would be INR 5,500 (10% on INR 55,000)

Principal amount in the third year would be INR 60,500 (55,000+5,500)

Interest earned in the third year will increase to INR 6,050 (10% on INR 60,500)

The addition of the annual interest continues during the entire investment period. Therefore, at the end of 20 years, your accumulated interest will be over INR 3.36 lakh because you choose to reinvest the interest.

Maximize your benefits by investing early

From the example mentioned above, it is seen that you are able to generate higher returns by investing for a longer period of time. When you invested INR 50,000 at 10% interest for a period of 20 years, you were able to accumulate more than INR 3.36 lakh. However, if you invested the same amount for a period of 10 years, your accumulated wealth would have been INR 1.3 lakh. You would have earned around INR 2.06 lakh less. Therefore, compounding provides maximum benefits when you start investing early. This is especially recommended when you want to plan your retirement. Investing when you are 35 years old will help you retire with four times the corpus when compared to beginning at the age of 50 years.

SIP and compounding

Investing in the stock market entails risk and requires basic knowledge and understanding of stocks. If you are not willing to assume this risk, you may opt for a Systematic Investment Plan (SIP) in an equity mutual fund. When you invest in SIPs, you are able to generate higher returns. An SIP means that you invest a specific amount at regular intervals in a fund. You may not have a huge amount for one-time investment and an SIP gives you the opportunity to invest in a disciplined manner. Over a longer period, SIP is able to generate significant returns.

In SIPs, investment does not entail high risk. It is an excellent way to reduce your risk against market volatility. It allows you to make small investments over a period to earn higher returns. Moreover, an SIP calculator will help you understand the potential returns you may earn through compounding.




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