How compounding and inflation shape our investment journey

K S Manojkumar

Two major concepts confront all beginner investors, early in their investment journey. Compounding and inflation. Ability to manage and account for these two factors largely determines how successful a person would be on his/her path to wealth creation.

Compounding is the formula through which your money multiplies over a period, when left undisturbed in investment tools like stocks, mutual funds, and bank accounts.

The compounding principle works so magically that Nobel laureate Albert Einstein called this formula the eighth wonder of the world.

Kept untouched, in an investment tool, the principal component of our money earns an interest (or return) in the first year. This interest component then merges into the principal component, fattening it a bit, to yield even better interest the following year.

When this cycle is allowed to continue undisturbed, the money may double every five to six years. A simple rule of thumb for estimating how long it takes for an investment to double is the Rule of 72. This formula is 72 divided by X, where X is the annual rate of return (or estimated return) on your investment (in stocks, mutual funds, debt funds, or a savings account).

The obvious lesson is the earlier you start your investment journey the better you stand to earn.

Now, let us investigate inflation. It is something that brings fear and apprehensions in the minds of investors. Inflation is the process that erodes the purchasing power of your money. For example, a Rs 1,000 note that could buy a specific brand of shoes in the year XX may no longer be enough to make the same purchase a few years later, as prices increase.

Money that sits idle, uninvested, is at the highest risk of being eroded by inflation. But even money invested in instruments that earn interest can lose purchasing power if the return does not outpace inflation.

If the current inflation rate is 6%, the investment should ideally earn at least 12% to ensure a net return of 6%, helping you reach your financial goals.

Between compounding and inflation lies the concept of risk. This is where investors must make decisions based on their risk profile, which consists of three factors: the need to take risk (aiming for higher returns), the ability to take risk (financial capacity), and the willingness to take risk (psychological readiness).

In conclusion, both compounding and inflation are powerful forces that shape your financial journey. While compounding can help your wealth grow exponentially, inflation can erode its value if left unchecked. The key to successful investing is to start early, choose the right investment vehicles, and aim for returns that can outpace inflation.