Compounding is the financial equivalent of a snowball rolling downhill. With each revolution, the snowball gets bigger because it picks up even more snow every time around. Compounding produces a snowball effect with money because the earnings each year contribute a little more to earnings the following year. As time passes, the earnings contribute more and more to the total value of an investment.
The longer the period of your investment, the more you accumulate, because of the power of compounding... which is why it makes sense to start investing early.
The secret is to start early
Meet Suresh and Manoj. Suresh invests Rs.5 OOO while Manoj invests twice as much. As illustrated in the table below, even though the amount invested by Suresh is half of what Manoj puts , his investment final amount is becomes twice as much as Manoj's, simply because he started earlier - a clear instance of the benefits of compounding. This is the power of compounding.
 Compounding Favours the Early Starter | |||||||||||||||||||||||||||||||||||||||||||||||||
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Assumed annual rate of return - 15% with dividends and capital gains reinvested. For illustrative purposes only
The key therefore lies in starting earlier, and giving your investments a longer time to grow.
Reinvest earnings and put your money to work
You may have noticed that our example assumes that dividends and capital gains aren't taken in cash. Reinvesting your distributions increases the value of your portfolio which, in turn, increases the amount of interest earned each year.
Just like our snowball growing larger with each roll, the value of the investment increases by a greater amount each year as the earnings are put back in. As time passes, earnings generated by the reinvested interest can rival or surpass the earnings that come from the initial investment alone.
The longer you have, the better compounding works
Money starts multiplying, more towards the end, as can be seen in the following graph:
The Power of Compounding
Growth of a monthly saving of Rs.1000 over a 30 year period
(Total savings: Rs.3.6 lacs)
Assumed rate of return - 12% For illustrative purposes only
Growth on top of compounding
The basic principles of compounding apply to any mutual fund. Namely, reinvesting earnings (dividends and capital gains for non-money market funds) over time can lead to potentially large increases in value.
If a fund's share price rises, your initial investment grows independently of the effects of compounding. Although there's no guarantee that a fund's share price will increase, coupling this kind of growth potential with compounding has been an effective strategy for many long-term investors.
source: Franklin Templeton
