Power of Compounding

What compounding is

With simple growth, a sum earns a return only on the original amount, so it rises by the same number of rupees each year. With compounding, each year's return is added to the amount and earns a return itself. Growth builds on growth.

The difference is small at first and widens with time, because the base keeps growing. Every rate in this lesson is an assumption for the arithmetic, not a forecast.

Three drivers

Three things decide the result: the rate of return, the amount invested and, above all, time, because each extra year compounds everything accumulated so far, not just the original sum.

So, for a given amount and a given positive rate, starting earlier leaves a larger sum. This holds when returns are positive, and returns on market-linked investments are not assured.

The Rule of 72

The Rule of 72 gives a quick estimate of doubling time: 72 divided by the yearly rate is roughly the number of years in which money doubles. At an assumed 12% a year, that is 72 ÷ 12 = 6 years.

It is an estimate. Compounding at 12% for 6 years multiplies money by about 1.97, a little under 2.

Compounding in reverse

Compounding applies to whatever return actually occurs. Returns on market-linked investments vary from year to year and can be negative, and then compounding works against the investor. A fall of 10% a year for three years turns ₹1,00,000 into ₹1,00,000 × 0.9 × 0.9 × 0.9 = ₹72,900.

Costs compound too. At an assumed 12% a year, ₹1 lakh becomes about ₹3.90 lakh in 12 years; at 11%, one percentage point lower because of a higher yearly cost, about ₹3.50 lakh (1.11 raised to the power 12 is about 3.50).

A systematic investment plan (SIP) spreads investing over time and can help with discipline; returns still depend on the fund and the market and are not guaranteed.

Rules at a glance

Key points

• Compounding means earning returns on the principal and on earlier returns, so growth accelerates over time.
• The three drivers are the rate of return, the amount invested and time.
• For a given amount and positive rate, an earlier start leaves a larger sum, because each extra year compounds everything accumulated so far.
• Rule of 72: 72 ÷ yearly rate ≈ years to double; at an assumed 12%, about 6 years.
• At an assumed 12% a year, ₹1 lakh grows to about ₹3.9 lakh in 12 years (₹2.44 lakh with simple interest).
• Losses and costs compound too, and actual returns can be negative.

Common misunderstandings

• The 12% used here is an assumed round number, not a rate any investment is promised to give: it was chosen because it divides neatly into 72.
• Compounding is not a guarantee of growth: it applies to whatever return occurs, and a negative return compounds as a loss.
• A 50% fall is not repaired by a 50% rise: ₹100 that falls to ₹50 needs a 100% rise to return to ₹100.

Questions people ask