Power of Compounding

In financial terms, the power of compounding is the increase in the value of an

investment over time due to interest and the same interest is added back to the
principal amount. The power of compounding is exercised by investors through the
principle of compound interest. In compound interest, you earn interest on your
principal amount, and the interest is added back to the initial principal amount
again, increasing the potential interest for the next cycle.

However, the power of compounding is not restricted to just the compound interest
but it extends to the idea of delayed gratification, where you add what you earn to
the principal amount.

For example, investors prefer stocks over FDs as the share market has provided
close to 16% returns when compared to 4-5% of FDs. As FDs come with
compound interest, the power of compounding works automatically. However,
with stocks, it is up to the investor when to buy and sell.

You and your friend have an exam next year which you have been planning to give
for several years. As the syllabus is extensive, you started studying a year before
the exam and are fully prepared for the year. However, your friend only started a
month before the exam, and you know even if he studies for 10 hours a day, he will
not be able to complete the whole syllabus in time. However, a little learning daily
over time will help you succeed in the exam.

The same applies to investing. You can’t invest a hefty amount and hope for it to
double or triple in a year. Wealth multiplication happens over time; all you have to
do is ensure that you keep yourself invested. The most important thing that ensures
wealth multiplication is the Power of Compounding.

To execute the power of compounding in the stock market, you should do detailed
technical and fundamental analysis to invest in stocks that can offer you a
minimum percentage of returns. Once you invest, you can re-invest any realized
profits.

There are two types of interest, one is simple interest and the other one is
compound interest.
Simple interest is paid only on the money you save or invest (i.e., the principal
capital).
Let us understand the power of compounding with the help of a simple example.
Suppose there are two investors Ram and Shyam who are looking for opportunities
to create more money with an initial investment of ₹1 lakh.
They spot an opportunity where interest can be earned @ 10% per annum and both
of them decide to stay invested for a period of 10 years.
Ram opts for interest being calculated as compound interest while Shyam opts for
interest being calculated as simple interest.

Example of Power of Compounding

Consider the following example for a detailed understanding of the power of
compounding.

The formula for Compound Interest: P (1 + r/100) n - P Where P is the principal

amount, n is the number of years, and r is the rate of interest.

Suppose you invested Rs 1,00,000 at the age of 20, and the stock is giving you
12% interest (capital appreciation) every year. You intend to invest for 10 years
and realize your total amount after the completion of the period.

Scenario 1: You withdraw the interest earned every year.

In this case, after 10 years, you would have earned Rs 1,20,000 (12,000x10) as
interest. With the principal amount being Rs 1,00,000, your total investment value
will be Rs 2,20,000 (1,00,000+1,20,000).

Scenario 2: You re-invest your interest every year and add it back to the
principal amount.
In this case, according to the formula, you will earn Rs 2,10,584.8 as interest after
10 years. With the principal amount being Rs 1,00,000, your total investment value
will be Rs 3,10,584.8 (1,00,000+2,10,584.8).
Thus, with the power of compounding, you will earn Rs 90,584.8 more than if you
withdraw your interest every year.

THANK YOU !!
Abhisek Das
abhisekdas1307@gmail.com
Group- Final Goaler 0610