Compounding refers to the reinvestment of earnings at the same rate of return to constantly grow the principal amount, year after year. It is a technique of making your money work harder for you and is perhaps the most powerful tool that an average investor can use to plan for many of life’s financial goals, including retirement.
Sameer and Sanjay are friends who have just started their career at 20 and plan to retire at 65. Sameer starts saving ₹5,000 every year from age 20 and continues to do so until he is 35 years old, after which he stops making any further investment. Sanjay, on the other hand, starts saving ₹12,000 every year from the age of 35 and continues to do so until he retires at the age of 65. If both earn, say, 12% per annum on their investments, which of them would be wealthier when they retire at 65? Sameer! Surprising, isn't it? At 65, Sameer would have accumulated 36.43 lakh whereas Sanjay's wealth would have been lower at 32.44 lakh.
The result would be the same even if one considers a one-time investment. For example, assume that Sameer invests ₹10,000 at the age of 20 in an instrument that fetches 15% per annum. Sanjay, on the other hand, invests
₹100,000 at the age of 40 in the same instrument. When both turns 60, Sameer's ₹10,000 investment would have grown to ₹26.78 lakh, while Sanjay's ₹1 lakh would have grown to only ₹16.37 lakh.
Thus, the longer you stay invested the more money you will make. The best way to take benefit of compounding is to start saving and investing wisely as early as possible. The earlier you start investing, the greater will be the power of compounding.