Power of compounding

Power of compounding

photo by orangeacid

Investment experts keep advising us to “invest for the long term,” mainly so that we may benefit from the power of compounding.

Take an individual who decides to invest Rs. 50,000 for 20 years. Assume that he earns a constant return of 8% per year. In the first five years, the Rs. 50,000 invested grows to Rs. 73,466. (see table) This means, he gains Rs. 23,466 in absolute terms in the first five years.

compounding

Year Value of the investment at the beginning of the year (Rs) Value of the investment at the end of the year (Rs)
1 50,000 54,000
5 68,024 73,466
6 73,466 79,344
10 99,950 1,07,946
11 1,07,946 1,16,582
15 1,46,860 1,58,608
16 1,58,608 1,71,297
19 1,99,801 2,15,785
20 2,15,785 2,33,048

From the sixth to the tenth year, he earns Rs.34,880, almost 50% more than what he did in the first five years. From the eleventh to the fifteenth year, he earns Rs. 50,662 and between the sixteenth and the twentieth years he earns Rs. 73,439.

The point is simple. Over longer time frames, the impact of compounding in absolute terms only gets more visible. And that is why investment experts say what they say.

Now, how does an investor implement such a strategy? A simple way of going about it is by opening a Public Provident Fund (PPF) account, which can be opened at a post office or any of the branches of State Bank of India. It pays an interest of 8% per annum. One can invest any amount between Rs. 500 and Rs. 70,000 in the account every year. The investment typically matures in 15-16 years and can thereafter be extended indefinitely in chunks of 5 years at a time.

The other strategy that can be applied is investing in tax-saving fixed deposits. An investment of a maximum of Rs. 1,00,000 can be made in such deposits. The tenure of the deposit varies from a minimum of 5 years to a maximum of 10 years. Currently, banks are offering rates of as high as 9% on these deposits. However, after 10 years, the individual will have to look at investing again in these deposits or look at some other mode of investing.

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Author: Austin Comments: 2 comments Date: 22 Sep 2008
Categories: Saving Money Tags: , , , , ,

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