The compounding effect can simply be compared with a snowfall effect. In a snowball effect, you can view a small snowball grow bigger as it rolls steadily down the slope. In a similar fashion, compounding assists in enhancing your investments by accumulating a higher return on the interest generated on the initial investment. In simpler terms, compounding essentially means generating interest on interest. 

Here’s how the compounding effect works in investment

Compounding effect, by far, is the most prudent effect wherein your investments earn returns on your principal investment and on previously earned interest. However, to make the most out of the compounding effect, you must remain invested for a long time period. Withdrawing your earnings before the investment period will not allow your investment to grow over time and earn the benefit of compounding. Here’s an example to make you understand better the power of compounding. Let’s assume you invested Rs 10 lakh for a span of 5 years in a mutual fund through a lump sum mode at an annual return rate of 14 % per annum.

YearOpening balance (Rs)Interest (14 per cent per annum)Closing balance (Rs)
110,00,0001,40,00011,40,000
211,40,0001,59,60012,99,600
312,99,6001,81,94414,81,544
414,81,5442,07,41616,88,960
516,88,9602,36,45419,25,414

Thus, your initial principal of Rs 10 lakh for 5 years will grow to over Rs 19 lakh. Note that by using an online power of compounding calculator, you can easily compute the benefit of compounding and the returns on investment generated over time. 

How can you get the maximum out of the compounding effect?

Here are the 3 major ways through which you can maximise your investments through the compounding effect – 

  • Start early 

If you begin your investments early, you hold the potential to remain invested for a long-time span. The longer you remain invested, the maximum time your investment will get to multiply and thus help you to accumulate a considerable corpus over a long time. Moreover, the longer your investment timeframe, the lesser amount you would need to invest to form a huge corpus. 

  • Make smart investment moves

As there are multiple financial investment options available in the market today offering the benefit of compounding effect, it is recommended you conduct your own research on distinct financial instruments and invest in the product with high return potential while factoring in your risk tolerance level. According to financial experts, it is a wise move to invest in equity mutual funds through the SIP mode if your goal is to generate massive wealth over the long term. An SIP is an instrument that permits you to make the most out of the compounding effect and gain the benefit of rupee cost averaging whereas equity mutual fund investments have the potential to outperform fixed-income assets and inflation over a long time period by a wide margin. 

  • Be disciplined and ensure to top up your existing investment

Many tend to avoid increasing their monthly investment with an increase in their income. Avoiding this step makes you miss out on the compounding benefit and the opportunity of generating higher wealth over time. 

Ending note

The benefit derived from the compounding effect is immense. You can generate massive wealth over the long term to support your long-term financial goals. All you must do is begin with your investments early, patiently remain invested for a long time period and ensure to top-up your existing investment as and when your income increases.