How does power of compounding works in the stock market?

To understand the power of compounding, one needs to understand compound interest first. There are two types of interest- simple interest and compound interest. In compound interest, the investment return gets re-invested back along with the initial investment amount.

Compounding refers to the process where the investments get multi-fold returns due to the manifestation of compound interest over a longer-term. Compounding in the stock market has a multiplier effect. It can be understood with the example of a snowball. A snowball gets significant mass at an accelerated pace once it gets rolled down from an ice hill. It adds small ice at each spin and becomes bigger and heavier as it covers more distance. Due to its multiplier effect, compounding is often referred to as the eighth wonder of the world.

We often hear stories of big wealth generation in the stock market. The power of compounding is often the central element in these stories. Let us take the example of Infosys. Infosys Ltd launched its initial public offering (IPO) in February 1993 and was listed on stock exchanges in India in June 1993. Infosys IPO came at Rs.95 per share. So Rs.10,000 invested at the time of the IPO would have turned into more than Rs.16 Cr if one has held the share to date.

That’s the power of compounding in the stock market. Infosys has rewarded its shareholders with bonus shares many times. Infosys also went for a stock split. It split the face value of its shares from Rs 10 to Rs 5 in 1999. The initial 105 shares that have come from investing Rs.10,000 increased to 1,07,520 numbers of shares.

There are numerous examples in the stock market like Infosys where the power of compounding has unleashed its power. Holding good business for the long term becomes extremely rewarding due to the compounding effect.

As Warren Buffett says “Time is the friend of the wonderful company, the enemy of the mediocre.

Warren Buffett also said that compound interest is an investor’s best friend and compared building wealth through interest to rolling a snowball down a hill. The more time your investment has to grow, the greater power of compounding it will achieve.

Also Read: Why you should start investing early?

As per an article published in Barron’s, one of Warren Buffett’s remarkable achievements is that he has generated over 90 percent of his wealth since he turned 65. This is because of compounding at play as it is back-ended.

A small incremental gain on regular basis can have a huge marginal impact over time. Author James Clear has shown that 1 percent better every day will result in 37 percent better at the end of the year.

Understanding the mathematics behind the power of compounding.

Compound interest formula:

A = P (1 + [r / n]) ^ nt

Here, A is the amount of money accumulated after compounding over an investment period including interest; P is the initial investment; r is an annual rate of interest, n is the number of times the interest compounded per year, and t is the number of years the initial amount get compounded.

Let’s understand with the help of an example:

Case I: Initial Investment = Rs 100,000

Annual rate of interest =14%

Time of investment= 25 Years

At the end of the investment period of 25 years, the investment would become Rs.26,46,192

Case II: Initial Investment= Rs 100,000

Annual rate of interest=15%

Time of investment= 25 Years

At the end of the investment period of 25 years, the investment would become Rs.32,91,895

From the above example, one can see how a mere 1% extra return compounded over a long time can create a huge difference in the outcome as in the first case investment gets multiplied by 26x and in the second case by nearly 33x.

Calculate how much wealth you can create in 25 years with the power of compounding calculator.

Therefore, it’s better to focus on “t” or the time duration of investment as one can get the full benefit of compounding due to its back-ended property.