Whether or not you fully understood it back in school or not, compounding actually plays a vital part in your investment making decisions.

Compounding, in the most basic sense, is the phenomenon of gaining interest upon interest. In essence, every compounding period, the interest rate is applied to not just the principal (amount you invested, deposited or took out as a loan) but also to any interest that has accumulated over time.

How Compounding works

For example, if an individual were to invest a monthly sum of Rs. 2,000 and continued to do so over a period of 25 years, assuming their rate of return to be at 8% per year, they could accumulate a total of Rs. 20 lacs. This would mean that they invested a principal sum of about Rs. 6 lacs which got compounded with interest to accumulate Rs. 14 lacs. The magic of compounding lies in the fact that as long as the money stays invested, the interest continues to get compounded and you no longer have to worry about it.

However, there are key things to remember when trying to get compounded returns, and let the magic of compounding work in your favour.

1. Have the consistency and discipline to keep the money invested in the same place from the beginning.

2. Let time work it’s magic, the more time that amount stays invested or is added to, the more money you take away in the end as compounding allows money to grow exponentially.

The beauty of time with respect to compounding, is that you could invest small sums from your income for a longer period of time and that would still likely amount to a larger return at the end of the investment than if you invested a larger amount for a shorter period of time.

For example, if one were to invest just a small sum of Rs. 2000 per month for 35 years, the value earned in total would come to Rs. 46 lacs. On the other hand, however, if one were to start investing Rs. 4000 a month, double of the previous sum, for 25 years, the sum at the end of the investment would only be Rs. 38 lacs. Hence, an important take away from this is that time and compounding go hand in hand.

Compounding and Investing Early

As you can see, there is a clear benefit to investing early. By giving compounding time to work, you are able to accrue wealth in far greater amounts than if you started late. The importance here is consistency, and by investing early, you build that financial discipline early on when it really matters. Since this investment is for the long run, which means you won’t feel compelled to withdraw any amount from the same. The more the money sits idle, the more you earn from it as it continues to compound over a period of several years.

Additionally, investing early helps you clearly define your financial goals. As you’re investing for the long run, you’ll need to properly research your investments. During this process, you’ll get a better sense of what kinds of returns you can expect on your invested capital and see if those are adequate to meet your financial goals in the long run.