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The power of compounding is the process where your investment earns returns, and those returns in turn generate their own returns over time. This has the potential to accelerate investment growth over time when returns are reinvested consistently.
The power of compounding is the process where your returns generate additional returns when they are reinvested over time. It’s often referred to as “interest on interest”. This means that not only does your initial investment grow, but the returns earned on that investment also start earning. Over time, this can lead to substantial growth, depending on market conditions and consistency of investments.
For instance, if you invest ₹10,000 and earn 10% annually, in the first year, you'll earn ₹1,000. In the second year, you'll earn 10% not just on ₹10,000, but on ₹11,000 — resulting in ₹1,100. This cycle continues, and over time, the growth curve becomes steeper.
The standard formula to calculate compound interest is:
A = P × (1 + r/n) ^ (nt)
Where:
A = Final amount (Principal + Interest)
P = Initial investment (principal)
r = Annual interest rate (in decimal)
n = Number of times interest is compounded per year
t = Time in years
If you invest ₹50,000 at an interest rate of 8% compounded annually for 10 years:
A = 50,000 × (1 + 0.08/1) ^ (1×10)
A = 50,000 × (1.08)^10 ≈ ₹1,07,946
Thus, the investment more than doubles in 10 years without any additional contribution.
Let’s look at a practical example:
Invest ₹10,000 at 10% annual return for 10 years
Future Value = ₹10,000 × (1.10)^10 = ₹25,937
Invest ₹1,000 per month in a mutual fund earning 12% annual return for 15 years
Future Value ≈ ₹5,00,000+
This shows that both lump sum and recurring investments can significantly benefit from the power of compounding — especially when started early.
In investment contexts like mutual funds or the stock market, compounding happens when returns — in the form of capital gains or dividends — are reinvested instead of withdrawn. This reinvestment increases the base amount, leading to exponential growth.
Examples include:
Systematic Investment Plans (SIPs) in mutual funds
Dividend reinvestment in equity stocks
Public Provident Fund (PPF), where interest is reinvested annually
Over time, the compounding effect becomes more powerful, especially for long-term investors.
Fixed Deposits (FDs) typically offer compound interest on a quarterly or annual basis. If you choose cumulative FDs, your interest is automatically reinvested.
Principal = ₹1,00,000
Interest Rate = 6.5% p.a.
Duration = 5 years (compounded quarterly)
Future Value = ₹1,38,915
This highlights how even fixed-income instruments benefit from compounding when the interest is allowed to accumulate.
Here are some key advantages of compounding:
Wealth accumulation from consistent investing
Exponential growth over time
Can contribute to long-term wealth planning
Maximises small savings with consistent reinvestment
Encourages long-term saving behaviour and discipline
The longer you stay invested and reinvest your returns, the greater the compounding effect.
The following factors affect the magnitude of compounding:
Starting early: More years result in more compounding intervals
Longer time horizon: Compounding typically unfolds over long periods
Higher return rates: Small changes in rate lead to big differences over time
Frequent compounding: Quarterly compounding results in more frequent growth periods than annual
Consistent reinvestment: Ongoing reinvestment maintains the compounding cycle
A one-year difference in the starting point can change the maturity amount over time.
Compound interest is the engine behind disciplined wealth building — and it rewards patience.
| Advantage | Explanation |
|---|---|
Exponential Returns |
Returns grow at a faster rate over time than simple interest |
Predictability |
Used in FDs and savings plans for reliable, consistent returns |
Supports Retirement Planning |
Long-term investments like EPF, PPF, NPS use compound interest to build corpus |
Reinvested Growth |
Makes your money work harder by building returns on returns |
The power of compounding highlights why starting early and staying invested matters. Whether through SIPs, FDs, or retirement schemes like PPF and NPS, compounding rewards discipline and patience. While actual returns depend on the product and market conditions, reinvesting consistently over long horizons can significantly enhance wealth creation.
This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.
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Posted on 19 Dec
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