Does Equity Give You the Profit of Compounding?

One fine day, I chose to invest my savings worth Rs. 1 lakh in a scheme offering me 12% returns per annum. I’ll get the interest credited to my account on the 28th of every month. There is a lock-in period of 3 years, and I can extend my investment until the next 10 years. On the other hand, I had one more scheme where I would receive 10% returns per annum compounded annually for 3 years, which can be extended further until 7 years. What do you suggest? Which one should I choose?

The first option seems lucrative. 12% returns, interest will be paid every month. But hear me out. I’ll go with the other scheme offering compounded returns.

Let me tell you why.

Option 1:

Option 2:

If I go with compounded returns, I get an extra benefit of Rs. 1051 within the same investment period and a lower interest rate. This is the beauty of compounding. You invest a principal and then make money on money. Various investment instruments offer compounded returns, including FDs, Public Provident Funds (PPF), Bonds, NPS Tier 2, etc. But does investing in equities provide you the benefit of Compounding? Let’s discuss.

The movement of capital markets depends on various micro and macroeconomic factors. The rising GDP over the years has contributed to the market’s growth. However, the 2008 financial crisis or the pandemic affected the market adversely. It is not just the company’s overall performance that affects the price of its shares but also the demand and supply in the economy. For example, if the price of petrol increases, it will affect not only the shares of companies like Oil India or Bharat Petroleum but also other companies like ITC and Brittania, as the transportation costs of these companies will increase.

Suppose I bought 100 shares of MRF Tyres in 2010; it would have cost me Rs. 6,59,500. The price per share in 2010 was Rs. 6595. If I would have invested, my principal would have grown to around Rs. 1 crore. According to this calculation, my investment would have compounded annually at approximately 76%. This shows the excellent work that compounding did. But, some companies have also swept off the market, and the investors’ money has declined to zero. For example, Jet Airways India’s share value lost its value recently due to the company’s poor performance, lack of demand, reduction in profits, etc. If I would have invested in this company, I would have lost the money and might not have recovered my principal as well.

Equity may provide you with returns better than other financial instruments, but applying the concept of compounding may not be suitable. There are equal chances of both profit and loss. Before investing, you must adequately study the company’s finances, market sentiments, and technical views. The returns that you earn may be excellent but are not risk-free.

To conclude, the beauty of compounding can be seen in fixed-income instruments like FDs, National Pension Scheme, Bonds, etc., where you get interest but not in equity as it is a market-linked investment. Always consider all the aspects of investing, including the risk involved and then choose wisely where to park your savings.