Meaning

The word compounding means that the initial returns or interest that you earned on investment becomes part of the invested capital or principle. Compounding takes place when the returns or interest generated on the principal amount in the first period is added back to the principal amount in order to calculate the interest for the following periods.

If you invested Rs. 1 lac every year from age 20 to 40 and compounded at 8%, then by 60 you would get Rs. 2.3 Cr. If you started 10 years late, invested from age 30 to 50, you would get Rs 1 Cr from 40 to 60, just Rs. 45 lacs. In all cases, you invested for the same 20 years!

So, what changed? You allowed the compounding to start early! So, with a pretty decent income and with a little self-control on spending you can start investing early. The way compounding works, the more you invest at a young age, the more your money works for you over time and the sooner you'll achieve financial freedom.

How to make Compounding work for you

1. You should start early

There is nothing like starting early to make the most of compounding. If you start investing from the time you start earning, it will make a solid base for you that will enable your wealth to grow further over a period of time.

2. Always follow Discipline

If you wish to create a healthy portfolio, it is very important that you define your financial goals and be regular in your investments. Regardless of how less you earn, knowing what your priority is and understanding how being disciplined now would pay off later, will help you develop the habit to keep money aside for investing.

3. Patience is the Key

A lot of us wish for quick returns and not realize that it is the long-term investments that really powerfully reap from the concept of compounding. You will have to allow your investment to grow at its own pace without meddling with it from time to time. Years of dedicated investment on your part will render a strong and healthy lump sum capital for you at the end.

Compounding in Stock market

Power of compounding looks quite clear from the point of view, debt and the interest being put back. But how will the concept of compounding work in case of equities? The concept is the same but the operation is slightly different. Every company has the choice to pay dividend from earnings. Generally, wealth is created by companies that can reinvest most of their earnings in the company at higher ROE. This drives growth and profit margins and enhances the stock price.

Warren Buffet’s Stock market wealth compounded growth is amazing

On his 59th birthday, Warren Buffett’s net worth was only $3.8 US Billion.

In 6 years, his wealth multiplied 4 times!

In 12 years, his wealth multiplied 9 times!!

In 18 years, his wealth multiplied 15 times!!!

At the age of 91 his net worth is $87.5 billion. So, his wealth has multiplied by 22 times in the last 32 years!!!!

Power of Compounding is practically a Superpower.

But investing early is winning only half the game. The second most important thing is to stay disciplined.

Over the years, stocks are the only investment option that has offered superior returns than any other investment option. Take a look at the below table:

Source: RBI and BSE website

Below given, some of the best performing Indian stock market companies with high compounding over the last 10 years period :

Finally, to ensure the power of compounding in stocks, they must show discipline and reinvest the profits to let the power of compounding do its magic. If the profits are withdrawn, the idea of the power of compounding becomes void as the principal amount will not get anything added to it, decreasing the return potential for the future.

Compound Interest Formula