Albert Einstein had once rightly said, "Compound interest is the eighth wonder of the world. He, who understands it, earns it. He, who doesn't, pays it." The concept of the power of compounding has been around for ages and plays a significant role in wealth creation.

Simply put, compounding is the financial equivalent of a snowball effect. Just as a snowball gains in size as it starts rolling and picking up more snow each time around, compounding produces the same effect with money as the earnings of one year contribute a little more to the earnings of the following year. As time passes, the earnings contribute increasingly to the total value of your investments.

Let us explain the concept in the form of a story I had read sometime back. The creator of the game of chess shared his invention with the ruler of the country. Impressed by the idea, the ruler asked the person to quote his price. The man was clever and quoted one grain for the first square of the chess board, two for the second one, four for the third one and so on, (doubling the number of grains on each subsequent square). The ruler readily accepted the offer without any hesitation. In fact, the ruler was offended as he felt that the person was asking for a meagre amount. However, when the treasurer calculated the amount, it turned out that it would take more than all the assets of the kingdom to give the person his reward. The person was beheaded.

Time is of essence

So, how is this relevant to one when it comes to investment? Compound interest is one of the most vital components of both personal and corporate finance. Clearly, while saving is the key to making wealth, one should never undermine the importance of time.

There are no dependable methods to quick riches. But there are proven methods to become wealthy which calls for patience and discipline. The best way to preserve ones future financial health is by starting to save today even if it means saving a paltry amount.

Start early

The amount of capital one starts with is not as important as starting early. Procrastination is a natural assassin of the opportunity in store. Every year you put off your investment plans takes you farther away from your financial goals.

On the face of it, compounding is innocuous and may be boring as well. So what if an investment gives a few per cent extra return? Some may wonder as to why they should start investing now. One may think that these decisions have a marginal bearing in the short run.

Don't be fooled by such thoughts. One needs to understand that short-term results are not as important as what is likely to happen over the course of your investment journey.

Let me try substantiating this by putting some numbers in place. In our daily lives, we hear of terms such as inflation. One might wonder what inflation will do in the long run. An inflation of 7 per cent at play on Rs 100 today will result in significant wealth erosion. This is because what you can buy for Rs 100 today, you will need around Rs 540 after 25 years to purchase the same thing.

Simply put, you will need 5.5 times of what you spend today in the days to come to continue with your current standard of living.

Many of us flatter ourselves by thinking one is getting fixed return and is beating inflation. This is not true. Actually, every year the wealth is de-growing and, thus, one is subject to wealth erosion. Hence, it is imperative to set financial milestones early in life.

Choose carefully

Completing a financial plan not only involves setting financial milestones but also calls for choosing suitable investment options so that these milestones can be accomplished. One needs to be careful here as a minor underestimation of return can have a cascading effect on your financial objectives, forcing you to make compromises in the years to come.

The income earned by us can either be spent or saved. If one resorts to saving and not investing, this saving would just sit there in a piggy bank or under our pillow.

Given that I have already explained what inflation can do to your money, I am sure you would have realised what the worth of this money would be if not invested in the time to come.

Now, let's say you invested an amount in an investment which can yield a 10 per cent return. In a span of 25 years, the Rs 100 will be equivalent to Rs 1,080, or more than 10 times. That's what compounding can do.

In the words of Ben Franklin, "Money makes money and the money that money makes, makes more money".

The writer is head of investment advisory, Motilal Oswal Private Wealth Management