Compounding—The Easiest Way to Generate Higher Income!
“Compound Returns are the 8th wonder of the world” – ‘Albert Einstein’
Thinking of investing your money? It’s a great initiative however, before you go ahead with it, you might want to learn about a very important concept called ‘Compounding’.
Compounding
In simple terms, with compounding you generate returns from your initial investment or savings. But that’s not all. Compounding also helps generate returns from prior investments.Basically with compounding the return on return repeating itself.
What is the difference between Compound Return and Simple Return?
People often fail to understand the difference between compound and simple returns. Let’s illustrate the differences between the two using the following example:
We will start with simple return. Suppose you have PKR 1000,000 and expect to receive a return of 12% for a period of 10 years. The return calculations with simple return would be as follows:
|
Year |
Principal |
Return Rate |
Returns |
|
1 |
1,000,000 |
12% |
120,000 |
|
2 |
1,000,000 |
12% |
120,000 |
|
3 |
1,000,000 |
12% |
120,000 |
|
4 |
1,000,000 |
12% |
120,000 |
|
5 |
1,000,000 |
12% |
120,000 |
|
6 |
1,000,000 |
12% |
120,000 |
|
7 |
1,000,000 |
12% |
120,000 |
|
8 |
1,000,000 |
12% |
120,000 |
|
9 |
1,000,000 |
12% |
120,000 |
|
10 |
1,000,000 |
12% |
120,000 |
Now let’s take a look at the compound return calculations. We will assume that the principal and rate are the same. The calculations would be as follows:
|
Year |
Principal |
Return Rate |
Returns |
|
1 |
1,000,000 |
12% |
120,000 |
|
2 |
1,120,000 |
12% |
134,400 |
|
3 |
1,254,400 |
12% |
150,528 |
|
4 |
1,404,928 |
12% |
168,591 |
|
5 |
1,573,519 |
12% |
188,822 |
|
6 |
1,762,342 |
12% |
211,481 |
|
7 |
1,973,823 |
12% |
236,859 |
|
8 |
2,210,681 |
12% |
265,282 |
|
9 |
2,475,963 |
12% |
297,116 |
|
10 |
2,773,079 |
12% |
332,769 |
What Are the Benefits of Compound Returns?
Just take a look at the differences in the Principal amount over the years and you’ll see how drastically different compound returns are from simple returns.
In case of compound returns the return of the prior year is added to the principal. This becomes your principal in the next year and the return is calculated on this amount. At the end of ten years, your overall return is 2,105,848.
On the other hand, in case of simple returns the overall return is 1,200,000. That’s a net difference of 905,848 which let’s be honest is quite significant. In fact, if we were to look at it in percentage terms, it’s a difference of 75.49%!
Feel that all of the aforementioned information is too overwhelming? You can always turn to financial experts at FinPocket for assistance. We can simplify even the most complex financial concepts for you. Contact us now!
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