The need to understand compounding

Investment and compounding are the two terms that are always used together. It is believed that the compounding effect on investments helps investors reach their financial goals in a time-bound manner. In fact, the whole relationship between investment, rate of return, and time can be presented in terms of a popular equation i.e., 

Amount = P(1+r/100)^t

Here, Amount = the final value of your investment

P = the principal amount invested

r = the rate of return achieved

t = the time for which money was invested

If you can memorize this easy equation and apply it to all your investments then in terms of investment knowledge you will be in the top 5% of investors. Most people don't understand the core meaning of this equation and keep on switching from one product to another in search of returns. The equation simply states that if you invest a particular amount and it grows at a rate of return and the successive returns are reinvested then with an increase in time horizon the amount will become higher and higher. Let's understand with an example.

Suppose you invested Rs. 1,00,000 and it grew by 10%, so post one year you will be having Rs. 1,10,000. Now, there are two scenarios.

1. In the first scenario you withdraw Rs. 10,000 i.e. the profit and keep your invested amount for the second year at Rs. 1,00,000. Assuming a 10% return for the second year, the end value will be Rs. 1,10,000. Total earnings for 2 years are Rs. 10,000 + 10,000 = Rs. 20,000.

2. What if you don't withdraw the money? For the second year, you will get 10% of Rs. 1,10,000 i.e. Rs. 11,000. Total earnings for 2 years are Rs. 10,000 + 11,000 = Rs. 21,000.

On an investment of Rs. 1,00,000 over two years the difference between two styles of investment is Rs. 1,000. Can you imagine the difference over a period of 20 years? It will be a mindboggling Rs. 3,72,750!!

So, to earn a higher return one should not withdraw the amount periodically and let the time do the wonder. And, this is what compounding is all about. Compounding is the process of making from the returns on the initially invested money. It is compounding that led to a difference of Rs. 3.7 lakhs in our example i.e. the interest which was invested again and again every successive year in the end helped us earn the additional amount. The higher the rate and the higher the time period the higher will be the compounding effect.

But, compounding is also a misunderstood concept. For the majority of investors, compounding is restricted to the "r" portion of the equation that is written earlier. Investors think that a higher rate of return is required for compounding to work. Little do they understand that that enabler for compounding is "t" i.e. the time period for the investment. A higher rate of return definitely amplifies the effect of compounding but without giving sufficient time even a higher rate of return may not lead to a huge corpus build up and ultimately the financial goals may remain unmet.

For instance, if you invest Rs. 1,00,000 and earn 25% each year for two years and then stop investment thinking that such returns won't come any further than you make a total profit of Rs. 56,250. But what if you remain invested for another three years and get a return of 10% for the next three years? You will end up earning a total of Rs. 1,07,970 over a period of 5 years. The problem is that people think that compounding only works when the rate of return is in good double digits say >20%.

In search of high return investors often make risky bets and lose money. The problem is not the risky bets. The problem is that the time horizon often doesn't commensurate with the risk that is being taken. Investment for 2 years in smallcap funds because they have returned 30% per year in the past 2 years is an example of investment style not commensurating with the investment horizon. These steps make the investment experiences bitter for thousands of retail investors.

Investors need to view compounding with a lens on the time. In short, for compounding to work one needs to expand their investment horizon. A return of 10% per year over 10 years is desirable than a return of 20% over two years before exiting without meeting your goals. One needs to have a long-term view of investments. Having a decadal (10 year) view can help investors generate huge wealth in the long term. And this will happen only when investors understand compounding. 

So, whatever the situation is, just stay invested. Choose the instruments that favor your risk profile. If you are a conservative investor then don't invest in equity. If debt compounds your money at 7% then also you will be able to accumulate wealth over time and even that is called compounding. And if you are aggressive then you may invest the majority of your corpus in equity. Understand the compounding equation well and know that in order to earn wealth you need to concentrate on time. The rate is not under your control but time is and make sure that you make the best out of it.