Power of Compounding and everything you should know about it

Investments are always considered superior for wealth accumulation when compared to savings. It has a wider margin for capital gains and some avenues such as stock market can get you high returns in a short time.

People invest their money in various avenues to get returns that could help them achieve their short-term or long-term goals. When investing in avenues like equities and mutual funds,there is a constant risk of capital loss. To avoid such situations, people use numerous tools and instruments, but there are much simpler ways such as ‘Compounding’.

What is Compounding?

Seasoned investors believe, returns should be reinvested for amplified benefits. Returns when re-invested secures your capital and simultaneously makes way for new investment sources. Compounding can be implemented in any investment avenue both for long term and short terms gains.

How does compounding work?

Investment sources offer returns periodically which are either deposited in the investor’s bank account or via cash payouts. These returns can be channelized fully or partly to invest in different sources. Here is an example which provides an insight into how compounding works.

Dinesh works for an international firm and has a monthly salary of INR 35,000. He has been planning to buy a motorcycle for himself which is worth INR 1, 00,000. Dinesh believes that by saving INR 10,000 every month,it will take 10 months to get the bike, which is way too late for him. So following his friend’s advice,he invested in mutual funds. He set the returns frequency on monthly and invested a sum of INR 10,000.

In the first month,the stock market performed well, and he earned INR 1000. This seemed pretty low to which he decided to invest in other sources like equity funds. He invested the recently gained INR 1000 in the stock market and decided to keep the mutual fund investment constant.

The coming month he had amassed around INR 5000 which was re-invested in the same sources. With the high investment amount equity funds bagged him returns amounting to INR 10000, while his mutual fund’s income stayed constant. For the next month,he invested INR 5000 in mutual funds and INR 5000 in the stock market. So now the invested amount was INR 15,000 in mutual funds and INR 10000 in equity. To support the investments, he decided to add INR 10,000 to each of the investment sources. Hence, by the end of the sixth month,he was able to amass INR 1, 00,000 to purchase the motorcycle.

Compounding is a basic and easy investment strategy that can be implemented for higher returns in a short duration of time. However, it is necessary to consider factors like tax and interest income for successful wealth accumulation. While it sounds easy to reinvest your earnings, the risks of investing should also be considered. This is where investing strategies come into play.

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