Topic 4 of 9~5 min read

Power of Compounding

Definition

Compounding is the process where returns on an investment generate their own returns over time. In the context of SIP, compounding means that the returns you earn in one period are reinvested and start earning returns themselves, creating a snowball effect that accelerates wealth creation over long periods.

In Simple Words

Albert Einstein reportedly called compound interest the "eighth wonder of the world." In a SIP, compounding works like this: Your ₹10,000 monthly SIP earns returns. Those returns are reinvested. Next month, your new ₹10,000 plus the previous investment plus the returns — all earn returns together. Over 5 years, this effect is moderate. Over 10 years, it becomes significant. Over 20-30 years, it becomes extraordinary. The key insight is that in the early years, your invested amount is larger than returns. But after a tipping point (usually 12-15 years), your returns start exceeding your total investment. This is when wealth multiplication truly kicks in.

Real-Life Scenario

Three friends — Amit, Bharat, and Chitra — each invest ₹10,000/month SIP at 12% annual return: Amit starts at age 25, invests for 30 years (till 55): Total invested: ₹36,00,000 (₹36 Lakhs) Total value: ₹3,52,99,138 (₹3.53 Crore) Wealth multiplier: 9.8x Bharat starts at age 30, invests for 25 years (till 55): Total invested: ₹30,00,000 (₹30 Lakhs) Total value: ₹1,89,76,351 (₹1.90 Crore) Wealth multiplier: 6.3x Chitra starts at age 35, invests for 20 years (till 55): Total invested: ₹24,00,000 (₹24 Lakhs) Total value: ₹99,91,479 (₹1.00 Crore) Wealth multiplier: 4.2x Amit invested just ₹6 Lakhs more than Bharat but got ₹1.63 Crore MORE. That is the power of starting early and letting compounding work.

Key Points to Remember

Compounding turns small, regular investments into large wealth over time

The earlier you start, the more powerful compounding becomes

Time is the most critical ingredient in compounding

After 12-15 years, returns typically exceed total investment

Staying invested through market cycles is essential for compounding to work

Compounding rewards patience and punishes frequent withdrawals

Even a 5-year delay can reduce final wealth by 40-50%

SIP + Compounding + Time = The most reliable wealth-building formula

Formula

Compound Interest Formula:
A = P(1 + r/n)^(nt)

For SIP:
FV = P × [(1+r)^n - 1] / r × (1+r)

The "compounding magic" happens because each period's returns become part of the next period's principal.

Numerical Example

₹10,000/month SIP at 12% return:

After 5 years: ₹8,24,867 (Invested: ₹6L, Returns: ₹2.25L)
After 10 years: ₹23,23,391 (Invested: ₹12L, Returns: ₹11.23L)
After 15 years: ₹50,45,760 (Invested: ₹18L, Returns: ₹32.45L) ← Returns exceed investment!
After 20 years: ₹99,91,479 (Invested: ₹24L, Returns: ₹75.91L)
After 25 years: ₹1,89,76,351 (Invested: ₹30L, Returns: ₹159.76L)
After 30 years: ₹3,52,99,138 (Invested: ₹36L, Returns: ₹316.99L)

Notice: From year 15 onwards, returns are growing much faster than investment.

Frequently Asked Questions

Test Your Knowledge

2 questions to check your understanding

Question 1 of 2Score: 0/0

At 12% return, approximately how many years does it take for SIP returns to exceed total investment?

Summary Notes

Compounding is the single most powerful force in wealth creation

Start SIP as early as possible — every year of delay costs significantly

Stay invested for 15+ years to experience the full power of compounding

Do not withdraw from SIP prematurely — you break the compounding chain

The Rule of 72 helps estimate doubling time: 72 ÷ return rate = years to double