Power of Compounding Explained
When it comes to saving for the future or for the retirement, it always important that the early you start the more beneficial it will be in terms of the returns you will get on the investment. People speak on the power of compounding so largely that it nearly creates the wealth at the time of your retirement. We will discuss the power of compounding in this article with a clear example of how it helps in creating wealth for the future.
When we say the power of compounding, we mean to stay invested as long as enough such that the money itself gets compounded every year until the time you wanted to withdraw the money. The true power is visible only when you start investing early in your career and give it enough time to show its power. Let’s see the example from the below two different case scenarios.
Case Study
Suppose you have two different individuals who wanted to save some money for their retirement. Both have a different attitude towards saving and the time from which they plan to save. We consider that the market and financial conditions are the same for both individuals. The only difference is their savings behaviour to explain the power of compounding
Individual 1
Individual 1 is the kind of person who spends a lot of money and believes less in the concept of early savings. he keeps on postponing his savings plans for the future. He thinks its always too early to start planning for retirement.
At the age of 40 years, the individual starts to save money for retirement. He starts to save ₹10,000 per month until the age of 60 years. Means the individual will continue paying the monthly instalment till he decided to retire at the age of 60 years.
The interest he will be receiving from the scheme in which he had invested is 12% per annum.
At the age of 60 years, the individual will have accumulated a wealth of around ₹99.91 lakhs. That is of course enough for a happy retirement. But before satisfying with the savings procedure followed by this individual, just look at the savings plan followed by Individual 2 below.
Individual 2
This individual wanted to start saving for the retirement as soon as he starts his career and at the age of 25 years, he started saving an amount of ₹5,000 per month. Assume that he invests in a scheme which gives a return of 12% every year. power of compounding
How to assume that the person has invested for around 10 years. That means every month the individual has invested ₹5,000 rupees. After 10 years the accumulated wealth of the individual is ₹13.01 lakhs. That is the amount he had saved by investing 5000 per month. Now, this is not the true power of compounding.
The next decision the individual has taken is to stop paying any more monthly instalment but keep that wealth as it is for the retirement in the same plan which gives an interest of 12%. This person never touched the investment until he reaches the age of 60 years. That means after 35years from the first payment of monthly instalment.
Now at the age of 55 years, the accumulated wealth of the individual will be ₹2.3 crores. That is more than enough to lead a happy life during retirement. This is the savings from just the investment of ₹5000 per month for 10 years. The individual may have other savings.
You can calculate yourself the returns from this link
True Power of Compounding
Now, this clearly shows the true power of compounding and how important it is to start saving early in your career. The longer you delay the more price you will pay for. Individual 1 continued to pay a monthly instalment for about 20 years. But whereas individual 2 paid instalments for only 10 years. Individual 1 paid a sum of ₹10,000 per month, whereas Individual 2 paid a sum of just ₹5,000 rupees.
In all the cases Individual 2 Benefitted just because he knows the power of compounding and hence started to invest early in the career.
