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How compounding works in stock market?

           You surely hear the word 'compounding'. But you don't know how it works? Then The article is only for you. The topic discusses the working process of compounding in stock market. Before know it you should know about simple interest and compoumd interest.

How compounding works in stock market?

             In simple interest you get interest on your investment amount(it is also called principal amount) on every year. For example if your investment amount is 1000 rupees and the yearly simple interest rate is 10% then after one year the amount will grow and it will be 1100 rupees because of simple interest. Next year or after two years you will not get interest on 1100 rupees. You will get interest on your principal amount(here 1000 rupees) and the total amount will be 1200 rupees according to 10% simple interest. After three years it will be 1300 rupees. Its next year(after 4 years) the capital will be 1400 rupees and after 5 years the total amount will be 1500 rupees.


Principal Amount  Interest  Time   Amount

         1000                    10%       1Y           1100

         1000                    10%       2Y           1200

         1000                    10%       3Y           1300

         1000                    10%       4Y           1400

         1000                    10%       5Y           1500  

So in simple interest you get the interest on your principal amount that you initially invest.


            But in compound interest the things are quite different. Here you get the interest on your principal capital and also upon your interest capital. For example if your investment amount is 1000 rupees and the yearly compounded interest rate is 10% then after one year the amount will grow and it will be 1100 rupees because of compounded interest. Next year or after two years you will get interest on your present total amount(here 1100 rupees) and the total amount will be 1210 rupees according to 10% yearly compounded interest. Similiarly after three years it will be 1331 rupees. Its next year(after 4 years) you will get interest on 1331 rupees and the capital will be 1464.1 rupees. Similiarly after 5 years the total amount will be 1610.5 rupees.


Principal Amount  Interest  Time    Amount 

         1000                    10%       1Y           1100

         1000                    10%       2Y           1210

         1000                    10%       3Y           1331

         1000                    10%       4Y           1464.1

         1000                    10%       5Y           1610.5


So after 5 years your 1000 rupees investment will be 1500 rupees according to 10% yearly simple interest. On the other hand after 5 years the principal amount of 1000 rupees will be 1610.5 rupees according to 10% yearly compounded interest. So you get the extra 110.5 rupees on your same principal and interest only for compounded interest instead of simple interest. The compounded interest means returns upon returns. It works as a magic. 


How does compound interest work in stock market?

---- As you are told before in the example the compound interest work in stock stock on the same way. Only the different is we can't see it clearly. For this we get confused. 


       Imagine you buy the shares of P company and you invest in the company as 1000 rupees/share. After one year the company will give you 10% interest on your investment then the amount will be 1100 rupees. Suppose its next year the company will give again 10% interest. Then you will not get the interest on 1000 rupees but you will get interest on 1100 rupees. So after getting 10% interest on 1100 rupees your total investment value will be 1210 rupees. Similiarly if next year(after 3 years) if the company will give 10% return then you will get interest on 1210 rupees and it will be 1331 rupees. So in stock market you get the returns on returns. It is called compounding


             So if you invest in stock market for long term term then your investment will automatically increase as compound interest. Only the difference is that the compounded interest is not seen to us. If you calculate the returns giving by your invested company then you can see the compounding upon your investment. Generally compounding is not seen in some first initial years after investment.  As much as the time pass you can see the power of compounding. For example if you invest 1,00,000 rupees in stock market and you get yearly 15% returns then after 28 years the capital will be 50,00,000 or 50 lakh rupees. And its 5 years or after total 33 years the 1 lakh rupees will be 1 crore rupees according to 15% compounded interest. With the compounded interest of 15% it takes 28 years to grow the capital from 1 lakh rupees to 50 lakh rupees. But the same growing of 50 lakh rupees takes only 5 years after 28 years. So in this way compounding works in long term rapidly. 


            The best example of compounding(how it works in long term?) in stock market is the investment of Warren Buffet. He earns yearly 18% compounded interest. There are many investors who earns more interest(such as one earns 66% returns) than him. But the net worth of warren buffet is currenly more than them. The reason is that the returns is of course less but the capital rapidly increases for long term investment. For this the amount becomes huge. So you should invest in stock market for long term and you should invest in those asset class where the compounding effect works on your favor. The compounding effect works on your favor in mutual fund investment. If you invest in mutual fund and you want to reinvest the dividend in your mutual fund scheme then you should select the growth options. 


          If you have any query related to compounding in stock market please comment below so that the topic can be covered.


Best wishes to invest.



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