What if I told you there was an almost sure-shot method of getting rich in the stock market?
Every day, thousands and thousands of investors all around the world flock to the stock market with one dream — to get rich. They start off with stars in their eyes and are rudely awakened when they crash and burn right back to the ground.
One of the main mistakes that people tend to make in the stock market is to exit their positions prematurely.
You don’t need any complicated formula to understand this base principle. The secret to making money is to stay invested long enough to see the powers of compounding.
Understanding Compound Interest
The main difference between simple interest and compound interest is that in the latter case, the interest earned each year is added back to the principal amount. This means, every year, the investment amount keeps increasing.
Let’s understand this with an example.
Let’s assume you invest a lump sum amount of Rs 1 lakh in a mutual fund that pays an average return of 10% per annum.
Investment amount = 1,00,000
Return rate = 10%
Profit after year 1 = 10,000
Now, under simple interest, this profit amount is kept separately. You don’t earn any interest on this money. The same amount is reinvested every year and you get linear or consistent growth.
Under compound interest, however, the profit amount gets reinvested at the same rate of return. In the second year, the investment amount is Rs 1.1 lakhs.
Investment amount = 1,10,000
Return rate = 10%
Profit after year 2 = 11,000
In the same manner, the interest earned in the second year gets added back to the original investment amount. This process continues and it leads to exponential growth in the long run.
|Compound Interest||Simple Interest|
As you can see, the same amount under compound interest yields an extra Rs 45,795 as compared to the simple interest.
How Compound Interest Can Work for You
To enjoy the full benefits of the power of compounding, there are two things that you require.
- A stable passive investment asset like mutual funds
With the growing popularity of mutual funds, investments have become ridiculously easy. The most difficult part of the entire process — the selection of the portfolio — has been entirely outsourced to experts!
Talk about the efficient division of labour!
Well, it has never been easier to take advantage of the exponential growth that compounding can unlock. You can choose any stable mutual fund depending on your risk appetite. Popular choices for long-term investments include blue chip funds, flexi-cap funds and hybrid funds.
After you’ve made your selection, you need to invest the amount you’ve saved and then forget about it for at least a decade. This might seem like a no-brainer, but it is not.
You see, the stock market is a free spirit, to say the least. It does not move in straight lines and it does not allow anyone to predict where it’s going to go next. There are dips galore in the short term. You will be tempted to take your money out and protect any profits that you’ve earned.
You’ve got to fight these instincts and stay invested. Don’t let short-term fluctuations take away from you the potential of the big picture. Only then will the powers of compounding work in your favour.