Compounding is one of the fundamental concepts of investing. It shows how money multiplies and grows over a period of time.
What is the compound interest?
As per Investopedia – Compounding is the process in which an asset’s earnings, from either capital gains or interest, are reinvested to generate additional earnings over time. This growth, calculated using exponential functions, occurs because the investment will generate earnings from both its initial principal and the accumulated earnings from preceding periods. Compounding, therefore, differs from linear growth, where only the principal earns interest each period.
“Compounding is one of my favorite words. Compounding is powerful. Warren Buffett did not become one of the wealthiest men in the world by suddenly striking gold in a single highly successful investment, but rather by compounding the value of Berkshire Hathaway at a 20 percent or so rate for 45 years. If an investor can achieve an average annual return of 20 percent, then, after 45 years, an initial investment of $1 million will appreciate to $3.6 billion. Wow! ” Ed Wachenheim
Impact of compounding on your investments
Investments is just not a money game but its a time game as well. With time investments grow, this is because of various reasons growth in the economy which results in growth in income and results in increased spending and the cycle continues.
Investments do not give a fixed percentage of returns for a very long period of time. They keep on fluctuating depending on the economic conditions.
Magic of compounding
Let’s take the example of 1 lakh invested and which earns you 30% per annum.
At the end of 10th year, 1 lakh becomes 13.78 lakh. Compounded at 30% per annum.
At the end of 20th year, 1 lakh becomes 1.9 crores. Compounded at 30% per annum.
At the end of 30th year, 1 lakh becomes 26.19 crores. Compounded at 30% per annum.
Impressive isn’t it? Well, that’s magic of compounding!