6. What is Compounding and How does it work?
Ali earned Rs. 10. Ali has a habit of charging additional amount of Rs. 5 if he lends his money to someone. Today, he lends Rs. 10 to his friend Amna. In 10 days, Ali gets his Rs. 15 back and decides to again give it to another friend – Azam. Azam returns Rs. 20 to Ali. This goes on and by the time Ali lend money to his 6th friend, he had accumulated a total of Rs. 40. This is the power of compounding!
Compounding simply means the ability to receive a return by investing in an asset and then regularly reinvesting the return earned previously to get a higher amount in the future. In the previous example, Ali kept lending the entire amount he got back from his friends which included the extra Rs. 5. Had Ali lend only the original earnings of Rs. 10 to Azam, he would have gotten back Rs. 15 only. That’s a return of 50%. However, Ali lends the entire amount of Rs. 15 (including Rs. 5 received from Amna) and therefore, received Rs. 20 from Azam. This is equivalent to a return of 100%.
The art of compounding is based on two factors: reinvestment of the income and time. The longer the time horizon, the higher the income-generating ability of your original investment i.e. Rs.10 in Ali’s example.