What is the Compounding and how it works?

Compounding in mutual fund

What is the Compounding? 

For many of the us, the power of compounding seems like a difficult topic. But it is not so difficult. I will make you understand this in a simple manner. If an apple is your initial investment and you reinvest the seeds of your apple it becomes trees, so over a long time of period you owns an orchard of apple. So same like apple, allow your money to make more money. In the case of mutual funds the power of Compounding is that, you gets Return on your initial investment and this return also invested with initial investment so the next time you gets Return on your initial investment plus previous return. Over a long time you can see the magic of compounding.

How compounding works

Let us take an example that an individual invested ₹. 10,0000 @ 12% p.a. The interest for the year would be ₹.12000. However, when the interest is also invested in the same investment, the earning next year would accrue on original investment of ₹. 10,0000 as well as on the additional investment of ₹.12000.This means, the earning for the second year would be ₹. 13440. As the years pass, the interest for the year keeps increasing since there is additional investment each year.

Investment : ₹. 1, 00,000

Rate of return: 12% p.a.

Investment period(years)Amount Accumulated (lacs)Earning (lacs)
051.76 0.76
103.102.10
155.474.47
209.658.65
2212.1011.10

The above calculation shows some interesting pattern. As the investment is held for long-term the earning keeps growing faster. While the earning in the first 5 years was ₹. 0.76 lacs, the same for the next 5-year period was ₹.1.34 lacs (₹. 3.10 lacs – ₹. 1.76 lacs). The earning in the last two year – was ₹. 2.45 lacs. “As the time goes, the earnings do not multiply, but grow exponentially.”

So compounding is the process of earning income on your principal investment plus the interest earned – the interest also starts to earn as the same is reinvested. So compounding is the process of earning income on your principal investment plus the interest earned – the interest also starts to earn as the same is reinvested.

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