How Does Compounding Work? the Power of Compounding

Compounding is so powerful that if used wisely, you could potentially turn the whole universe into your own personal bank and one of the wealthiest beings ever in existence. In simple terms, compounding is when the money that you put in starts earning money and then again this new sum of money further starts yielding more.

This is what's commonly known as “interest on interest,” and even though it sounds quite simple, the effect of this can be very significant given time to work.

topics :-

1. The Basics of Compounding
2. The Compounding Formula
3. The Power of Time in Compounding
4. Real-Life Case Study

The Basics of Compounding :-

Compounding is when the returns of an investment, whether from interest, dividends or capital gains, are reinvested to generate additional earnings over time. It is basically a method of letting your money work for you and be able to grow itself.

So, for instance — You Invest ₹10,000 at a return of 10% annually. After a year, your investment of ₹10,000 will become ₹ 11,000 (₹1,000 return) And at the end of the second year, you will get 10% return on ₹11,000 amount which is ₹1,100 and it will make the total ₹12,100. It is the sum of previous year capital plus interest on a 12% interest per annum, So next opening balance will be the closing balance for previous year, in this case end of first year. And thus the return will be calculated in total ₹10'000+₹1'200=11'200. In the third year he/she would calculate his/her return by adding ₹10'000 to existing fund value and so on. Which grows really fast over time, because of the “interest on interest” concept.

The Compounding Formula :-

The formula to calculate compound interest is simple :-

A=P(1+rn)nt

A = P \left(1 + \frac{r}{n}\right)^{nt}

A=P(1+nr​)nt

Where :-

A = the future value of the investment

P = the principal amount (initial investment)

r = annual interest rate (in decimal form)

n = number of times the interest is compounded per year

t = the number of years the money is invested

Let’s break it down with a basic example. If you invest ₹10,000 at an annual interest rate of 10%, and the interest is compounded annually, after 5 years, the investment will grow to :-

A=10,000(1+0.101)1×5A = 10,000 \left(1 + \frac{0.10}{1}\right)^{1 \times 5}A=10,000(1+10.10​)1×5

After solving this, the investment would grow to ₹16,105 after 5 years.

The Power of Time in Compounding :-

One of the key factors that makes compounding powerful is time. The longer you let your money compound, the more you benefit from it. Let’s take two scenarios to illustrate this.

Scenario 1 :- Investor A invests ₹1,00,000 at age 25 and earns an average return of 8% per year. He lets the money grow for 40 years, until he turns 65.

Scenario 2 :- Investor B invests ₹1,00,000 at age 35, earning the same 8% return per year, but only allows it to compound for 30 years.

By the time Investor A reaches 65, their investment will have grown to approximately ₹21,72,000, while Investor B's investment will grow to about ₹10,06,000. The difference? A staggering ₹11,66,000, which demonstrates the crucial role time plays in the compounding process.

Real-Life Case Study :-

Warren Buffett’s Wealth :-

One of the best examples of the power of compounding is the "Story of Warren Buffett."

Warren Buffett, one of the world’s wealthiest individuals, began investing at a young age. He started by investing in stocks and businesses and allowed his money to grow through the power of compounding.

At age 11, he bought his first stock. But it wasn't until later in his life that the compounding effect really took off. Most of his wealth came after the age of 60, showing how compounding gains become exponential over time.

For example, if Buffett had stopped investing at age 30, he would not have become as wealthy as he is today. His continued investment and reinvestment of returns allowed his wealth to grow dramatically. Today, at over 90 years old, he is worth billions—much of it due to compounding.

The takeaway: The earlier you start investing and let your returns compound, the greater your wealth will grow over time.

Warren Buffett, one of the most successful investors in the world, is often cited as an example of the power of compounding. Though Buffett started investing at a young age, most of his wealth came after he turned 50. In fact, about 90% of his wealth was generated after he turned 65.

Buffett’s strategy was simple :- invest in solid companies with strong fundamentals, reinvest the profits, and let time do the rest. For decades, he consistently earned returns of around 20% annually. Over time, those returns compounded, allowing him to amass one of the largest fortunes in the world.

What’s remarkable about Buffett’s success isn’t just his investment strategy but the sheer length of time he allowed his investments to compound. He started investing at age 11, and by letting compounding work for over seven decades, he was able to grow his wealth to over $100 billion by 2020.