What is the Power of Compounding? | IIFL Knowledge Center (2024)

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What is the Power of Compounding? | IIFL Knowledge Center? ›

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 Principle of Compounding Knowledge

This concept teaches us that our capacity to learn and grow is exponential, depending on how we harness our new insights.

When you invest, your account earns compound interest. This means, not only will you earn money on the principal amount in your account, but you will also earn interest on the accrued interest you've already earned.

Power of compounding is essentially an act of 'adding interest on interest,' i.e. the amount of money you invest will generate earnings from both the initial principal amount and the accrued earnings from preceding compounding periods. Eventually, thus, power of compounding helps grow your wealth over time.

Compounding works because when you're constantly learning new information, you're stacking skills and making new connections you otherwise wouldn't have. Skill building creates numerous new relationships between ideas and knowledge, which act like bridges between the dots and can spark innovative thinking.

Compounding Knowledge Explained

The more he reads, the more he can read. If two people read the same thing, the person with the larger knowledge base will learn more. If you read a book you read 10 years ago, you will learn more from rereading it today. This is because you connect the ideas to a larger knowledge base.

In conclusion, the power of compounding can be leveraged in both fixed deposit and mutual funds to generate substantial returns over time, but mutual funds have the potential to generate higher returns as they are invested in a diversified portfolio of securities, which have the potential to grow faster.

Compounding is the process whereby interest is credited to an existing principal amount as well as to interest already paid. Compounding thus can be construed as interest on interest—the effect of which is to magnify returns to interest over time, the so-called “miracle of compounding.”

Let's say you have $1,000 in a savings account that earns 5% in annual interest. In year one, you'd earn $50, giving you a new balance of $1,050. In year two, you would earn 5% on the larger balance of $1,050, which is $52.50—giving you a new balance of $1,102.50 at the end of year two.

What is the 8 4 3 rule of compounding? ›

After the first doubling, it will double again in the next 4 years, and then a final time in the subsequent 3 years. Applying the 8:4:3 rule means that your mutual fund investment will quadruple over 15 years and increase eightfold in 21 years.

“The first rule of compounding: Never interrupt it unnecessarily.” - Charlie Munger. Charlie Munger's quote, "The first rule of compounding: Never interrupt it unnecessarily," emphasizes the power of compounding in financial and non-financial contexts.

The power of compounding helps a sum of money grow faster than if just simple interest were calculated on the principal alone. And the greater the number of compounding periods, the greater the compound interest growth will be.

For compounding to work, you need to reinvest your returns back into your account. For example, you invest $1,000 and earn a 6% rate of return. In the first year, you would make $60, bringing your total investment to $1,060, if you reinvest your return.

This is the power of compounding. Let's understand it with an example, if you decide to invest Rs. 2,00,000 at a rate of return of 10% today, then at the end of 5 years, your maturity amount will be ~ Rs. 3,22,102.

Wealth Grows Exponentially

This is the concept that makes the snowball grow larger every day. Principal grows faster the more frequent interest is compounded. Compounding works especially well when it's allowed to build over time, something Buffett learned at an early age.

Knowledge compounds. This means that learning doesn't grow in a linear way. When you've acquired a large amount of knowledge and skills, the new knowledge you learn has much more value than if you hadn't learnt that much. This key insight has the capacity to transform your career and your life.

The power of compounding interest allows your money to grow exponentially over time, especially the more you invest initially. You can also use the Rule of 72 to understand inflation's impact. By dividing 72 by the inflation rate, you can estimate how many years it takes for your money's buying power to be cut in half.