Compounding is the concept of continually reinvesting the earnings from an investment to generate more earnings, which are also reinvested to earn more, thereby growing the value of the investment over time. To put it differently, compounding is the process of generating earnings from both the initial capital and the earlier earnings on the capital.
The term compound interest refers to the sum of the accumulated earnings over the specified period. That is, the interest earned on the principal amount is reinvested, and it earns an additional interest — the accumulation of both the interest on the principal and the interest on the earlier interest is called compound interest. So, compounding is basically a process of earning compound interest on an investment. Compounding is a simple concept but very powerful because it has a multiplier effect on the initial capital — the ability of the investment to generate earnings from not only the initial principal invested but also the subsequent interest earned over the coming period. No wonder Albert Einstein referred to it as the 8th wonder of the world: “The magic of compounding lies in the fact that it can help investors multiply their returns over the long-term”.
The more time you give your investments, the more your earnings would accumulate. So, to take full advantage of the power of compounding, you have to start investing early so that your investment will have enough time to accumulate and compound earnings. However, what you earn depends on the rate of returns, as that is what accelerates the income potential of your original investment.
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