Everyone wishes to create huge wealth but very few know how to do it. It is important to understand that you will be able to create wealth only if you can grow your money at a higher rate than inflation.

And how is this possible? Well, let the magic work on your invested money.

This magic which converts money inflows into abundant wealth is called the power of compounding. Einstein considered the power of compounding to be the 8th wonder of the world. Let us understand why he felt so.

What is Compounding?

Compounding is when you let the interest earned on your invested money further earn more interest for you. This is possible only if you do not withdraw the gains as and when you earn them.

I would like to explain this with the help of an example. Let’s say Vikas and his friend Rajesh both invest Rs 1,00,000 today at 12 per cent p.a. for 25 years. Vikas kept on withdrawing the gains at the end of every year and thus, after 25 years, he received Rs 1,00,000 only. He made gains equivalent to Rs 3,00,000 in these 25 years.

On the other hand, Rajesh kept the money invested for 25 years and did not make any withdrawal. You will be astonished to know that Rajesh will have accumulated approximately Rs 17 lakh by just investing Rs 1 lakh. This is what we call the power of compounding.

Although both the friends are earning 12 per cent p.a. but letting your gains earn more gains will help you multiply your wealth manifold. In this case, nearly 20 times more. So, it is highly suggested to remain invested for a longer time to create more wealth.

Start Early

Now that we have understood the power of compounding, it is important for all of us to know that investment tenure plays a big role in showing the positive and much greater effect of the power of compounding. Even though you do not withdraw your money in between till you reach your goal, there are chances that you are not able to grow your wealth substantially. The only reason being that you started investing late.

Again, let's understand this with the help of an example where two people started investing for their retirement in an equity mutual fund through SIP earning 12 per cent p.a.

Let’s say A started investing Rs 5,000 from the age of 25. He was of the view that because he doesn’t have any responsibilities at that moment he can start investing. On the other hand, B started investing at the age of 40 as he wanted to splurge and enjoy life in the initial years of the earning phase. But when he started investing, he invested Rs 15,000 monthly.

On reaching retirement at the age of 60, A accumulated around Rs 3.2 crore whereas B could accumulate just Rs 1.5 crore approx. Please note that although Mr B invested more i.eRs15,000 monthly and a total of Rs 36 lakh compared to Rs 21 lakh that Mr A invested, he still could reach just half of what A made.

It can be seen that the power of compounding will definitely help you significantly in wealth creation. However, you should keep two things in mind to increase its impact. Firstly, you need to start early and invest for a longer tenure as time matters more than the size of the investment, and secondly to not withdraw to avoid hampering your wealth creation process.

The author is the Founder of Fintoo

DISCLAIMER: Views expressed are the author's own, and Outlook Money does not necessarily subscribe to them. Outlook Money shall not be responsible for any damage caused to any person/organisation directly or indirectly.