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Below are Views On Exploring the power of compounding in this new year

While starting out on their investment journeys, people continue to hear about the benefits of long term investments. Did you know what makes long-term investments grow in value the way they do? It is the power of compounding! However, compounding is not necessarily a good thing in finance. Time to understand the nitty-gritties of the process of compounding. This new year, start your financial journey afresh by leveraging the power of compounding to your favour.

What is the power of compounding?

The power of compounding, also referred to as the miracle of compounding, is basically a process of reinvestment. Suppose you invest ten thousand rupees in a scheme for two years. This money is called your capital amount. Now, when your money grows by compounding, the amount you earn as interest over one cycle of compounding is reinvested into the capital amount. Over the next cycle, you earn interest over your capital, and the interest earned over the first cycle. Compounding can happen daily, monthly, quarterly and annually, although annual cycles are commonly used.

A fun fact

Did you know that Alber Einstein is known for his famous saying on the power of compounding too? In essence, this is what he had to say: Compound interest is the eight wonder of the world - one who understands it, earns it, and those who don’t, pay it. In the coming year, make this a philosophy to live by, and recognize how you can make your money work smarter for you, rather than the other way around

Compounding can work against you - avoid this

Compounding is not at work in investments only - in fact, compounding can affect you negatively in an exponential manner. Credit cards are an excellent example of how compounding can destroy finances in a matter of a few years, if misused. Credit cards calculate the interest you pay over the borrowed amount in a compounding fashion. This means that if you left your unpaid balance unattended for two months, then the interest you had to pay for the first month will be added to the unpaid balance for the second month, and now, the interest will be calculated on the combined amount.

Over long periods of time, accruing credit card interest can take your finances in a downward spiral, and dig a deep hole in your finances. To avoid this, it is crucial to recognize the power of compounding at play in the accumulation of credit card debt. In the coming year, make it a monthly practice to attend to pending credit card payments, and treat your debt as a top financial priority.

Compounding can work for you - adopt this

As we noted in the example while understanding how compounding works, you can leverage it to your benefit too. In fact, a number of investors are attracted to long term investment opportunities for this very reason. Recognizing how compounding can take your finances to the next level will also give you the power to leave your long-term investment plans untouched on rainy days.

The stock market is full of opportunities where you can make compounding work in your favour. Let’s check out the first one.

If you have traded in stocks, you must already know how gains are made through stock trading. Long term investments in select stocks entitle you to what is called dividend earnings - this is an additional amount of money that is distributed to shareholders when they hold the stocks of a company beyond a specified time period. A great strategy to make compounding work in your favour here, is to reinvest the amount of money you earn through dividends back into shares of the same company. These are also called dividend reinvestment plans.

Dividend reinvestment plans help investors maximize the potential of their earnings at a given level of risk tolerance. By injecting the dividend earnings back into the same stocks, you increase the size of your capital amount in the beginning of each cycle - in the long run, this can drastically alter the shape of your funds.

Another way in which compounding can work in your favour is through mutual funds. While mutual funds help you grow your money on a compounding basis through one time investments too, systematic investment plans can help you leverage it more effectively in the long run. This is why: one-time investments require you to build sizable chunks of money before you put it to work. With systematic investment plans, you can achieve new financial heights with small habits.

Mutual funds help you reinvest your dividend earnings in a timely manner, over and over again, back into your capital amount. While your asset appreciates in value at handsome rates that the best of the equity market has to offer, a systematic reinvestment also works to increase the size of your fund. This is a key recipe in the success of mutual funds in India.

A gift to your future self

This new year, take a step towards knowing the power of compounding and long term investments, and give your financial life a new start, with Angel Broking - open a free demat account, and start giving your financial resolutions a new shape, by leveraging the power of growth with equity markets. And don’t forget to check out Angel Broking’s top picks in the stock market for this new year - our gift to you for starting the year with a #smartsauda, that will lay the foundation of long-term prosperity, and rejuvenate your finances with the power of compounding. Here is us wishing you a happy new year!

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