The Power of Compounding

Benefits of Compounding:

There are two things that are required while using the compounding strategy, investment earnings and time. Compounding is considered to be a long-term investment strategy.

When you decide to reinvest the interest amount then you open another source of income by generating returns from the interest earned. In this manner you are converting the investments into an income-generating resource where your money is working for you to generate wealth. This is the benefit and power of compounding, if invested in the right assets, it can help you generate enormous wealth.

How does compounding work?

To understand how compounding works, let us assume that you have investment Rs 20,000 in a scheme that offers an annual interest pay-out of 5%.

After the first compounding period (first year), your total amount in the savings account would rise to Rs 21,000. That is, 5% of Rs. 20,000 works out to Rs. 1,000 by the way of interest and is added to the principal amount. Compound interest comes into play only from the second year, in order to generate the interest required to reinvest in the market.

After the second compounding year, it is this enhanced principal of Rs 21,000 that sees a growth of 5%, which works out to an overall gain of Rs 1,050. This takes your balance to Rs 22,050. Here, both the principal and the interest earned has seen growth.

How does compounding work in the stock market?

Compounding in the stock market is a bit trickier compared to predetermined returns from a bank deposit. There is no rising value of returns per se. It is the value of the stocks you hold that gets compounded.

Let us elaborate on the above example. You invested Rs 20,000 in Company A. The first year you see a rise in your shares by 5% to Rs 21,000. Once again, compounding will become apparent only from the second year.

The second year also the shares see a rise of 5%, this means your holdings are worth Rs 22,050. But do bear in mind that the stock market is a fragile place to invest in, you can also lose if your holdings lose value.