Power of Compounding: 3 easy-to-apply rules to learn how Rs 3 lakh lump-sum investment grows at a given rate of return over time

Power of Compounding: Patience is the key when it comes to tapping the true power of compounding. Three simple principles, formulas rather, can both provide clarity and help you estimate your returns over time at a given expected rate of return. These three rules are: Rule 8:4:3, Rule of 72 and Rule of 114. In this article, we will learn with examples how these rules can give you an estimate of how your lump sum investment of say Rs 3 lakh may grow over time at a particular return.

How Power of Compounding Works | 3 rules to help you plan your long-term investments

First things first, these rules are just mathematical combinations that deliver standard results based on certain fixed conditions. For instance, the 8:4:3 rule is a time-tested strategy for estimating the potential growth of your mutual fund investments.

The Rule of 8:4:3 suggests that at an estimated fixed annual return of 12 per cent, your investment doubles in eight years, then again in the next 4 years, and finally in 3 years. So all in all, it tells you that your investment may quadruple in roughly 15 years if you get an annualised return of 12 per cent consistently.

So, if you’re invested in an instrument that delivers at least 12 per cent return annually, a lump sum investment of Rs 3 lakh will grow all the way to at least Rs 12 lakh at the end of about 15 years (8 + 4 + 3).

Rule of 72

This rule simply estimates how long it can take for an investment to double in value at a given interest rate.

How to use it

Simply divide 72 by the expected annual return to determine the number of years required for ithe investment to double in value from the initial amount.

Suppose you invest Rs 3,00,000 at an annual interest rate of 8 per cent. To calculate how long it takes for your investment to double:

72 ÷ 8 = 9 years

Your investment of Rs 3,00,000 will double to Rs 6,00,000 in approximately 9 years at a given rate of 8 per cent.

Suppose you invest Rs 5,00,000 at an annual interest rate of 12 per cent. To calculate how long it takes for your investment to double:

72 ÷ 12 = 6 years

What that means is your investment of Rs 5,00,000 will double to Rs 10 lakh in approximately 6 years.

The Rule of 72 offers a straightforward method to estimate how long your investment will take to double at a particular interest rate.

Rule of 114

Similarly, Rule 114 gives you the estimated time needed for your investment to triple.

The user has to simply divide the number 114 by the annual interest rate to determine the number of years.

What is compounding really and how does it work?

Compounding is a phenomenon that involves the addition of interest earned at given intervals back into the principal, thereby enhancing your overall return by a great deal. Simply put, your investments grow exponentially by compounding as your accumulated interest helps you earn more interest, leading to surprising returns over time.

Think ‘interest on interest’. This is the best way to understand compounding, and how the longer you wait into an investment offering compounding, the more lucrative is its outcome. Under compounding, your interest is incrementally added to your principal at regular intervals which then earns interest at a rate higher than in the case of simple interest.

One can apply these three easy-to-follow and easy-to-apply rules to achieve significant growth and financial success.

Catch all the latest stock market updates here. For all other news stories in buzzing categories ranging from technology and automobiles to personal finance, visit Zeebiz.com.