Compounding is often called the most powerful force in investing. In simple terms, compounding means earning returns not just on your original investment but also on the accumulated returns from previous periods. For SIP investors, compounding is the engine that transforms modest monthly contributions into a substantial wealth corpus.
Simple Interest vs Compound Interest
With simple interest, you earn returns only on your original principal. With compound interest, you earn returns on your principal plus all previously accumulated returns. The difference becomes dramatic over longer periods. A Rs 1 lakh investment at 12 percent simple interest becomes Rs 3.4 lakh in 20 years. The same amount at 12 percent compound interest becomes Rs 9.6 lakh. That is nearly 3 times more, just from the power of compounding.
Compounding works best with two ingredients: a decent rate of return and a long time horizon. Even a modest 12 percent annual return can create extraordinary wealth over 20-30 years.
The Rule of 72: A Quick Mental Math Tool
The Rule of 72 gives you a quick estimate of how long it takes to double your money. Simply divide 72 by your expected annual return rate. At 12 percent return, your money doubles every 6 years (72 divided by 12). So Rs 10 lakh becomes Rs 20 lakh in 6 years, Rs 40 lakh in 12 years, Rs 80 lakh in 18 years, and Rs 1.6 crore in 24 years. Each doubling adds more absolute value than all previous doublings combined.
| Year | Corpus Value | Doubled From | Absolute Gain in Period |
|---|---|---|---|
| Year 0 | Rs 10 Lakh | - | - |
| Year 6 | Rs 20 Lakh | Rs 10 Lakh | Rs 10 Lakh |
| Year 12 | Rs 40 Lakh | Rs 20 Lakh | Rs 20 Lakh |
| Year 18 | Rs 80 Lakh | Rs 40 Lakh | Rs 40 Lakh |
| Year 24 | Rs 1.6 Crore | Rs 80 Lakh | Rs 80 Lakh |
Compounding in the Context of SIP
With SIP, compounding works on every single monthly installment. Your first installment compounds for the longest period, and each subsequent installment compounds for slightly less time. The cumulative effect of all these installments compounding together creates a growth curve that starts slowly but accelerates dramatically in the later years.
- In a 20-year SIP, nearly 70 percent of the final corpus comes from compounding returns, not your invested amount
- The last 5 years of a 20-year SIP contribute more to total wealth than the first 10 years
- This is why premature withdrawal destroys wealth — you are leaving the table right before the biggest gains
- A Rs 5,000 SIP started at age 25 can create more wealth than a Rs 15,000 SIP started at age 35, both ending at 55
Think of compounding like a snowball rolling downhill. It starts small and slow, but as it rolls longer, it picks up mass and speed exponentially. The key is to let it keep rolling.
Three Enemies of Compounding
- Premature withdrawal: Pulling out money breaks the compounding chain and you lose future exponential growth
- Irregular investing: Skipping SIP installments reduces the total capital base available for compounding
- High expense ratios: Even a 1 percent higher expense ratio can reduce your final corpus by 15-20 percent over 20 years
Compound interest is the eighth wonder of the world. He who understands it, earns it. He who does not, pays it.