Power of Compounding: Compound Interest Explained

This thread was originally posted by Meenank Minnu on 5th September 2020 on our FinTalks Facebook Group. I added some extra lines at the end to make it comprehensive.

What is compound interest?

Compound Interest is the addition of interest to a principal sum of a loan or deposit, or in other words, interest on interest.

It is the result of reinvesting the interest, rather than paying it out, so that the interest in the next period is then earned on the principal sum plus previously accumulated interest.

Einstein quoted Compound Interest as the 8th wonder of the world. :wink:

Here is an example:

If rs 100 attracts 10% interest in one year, then we know that it gained rs10, turning 100 into 110.

You’d start the 2nd year with 110, and if it increases by 10%, it would gain rs11, turning rs110 into 121.

You’ll go to the 3rd yr with 121 in your pocket, and again 10% to it would be 12.10 extra gain making it rs133.10

This is the reason why we invest long-term to harness the power of compounding.

Where does the Power of Compounding Apply to?

One of the major areas where the Power of Compounding comes into play is the Fixed Deposit Renewals getting re-invested if you do not choose to redeem them. It also applies to Recurring Deposit Schemes as you keep investing a fixed amount of money, the previous principal + interest + newly added principal amount, all goes into your next investment tenures.

The power of compounding also applies to mutual funds, since you keep on doing SIP over a long period. However, this is NOT always fundamentally correct, as markets never go in an upwards fashion continuously. Same with the stock market.

But yes, if you consider the daily tenure of ups and downs, whatever you gain or lose today is reinvested the next day, and so on. So, a certain compounding does take place there. Over a long period (say, 5-10 years), you will accumulate a good amount to see some power of compounding over monthly or yearly returns, irrespective of the daily market fluctuations.

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