Demystifying the Magic of Compounding: How It Works & Why It Matters

WarrenBuffet once said, “My life has been a product of compound interest”, and that alone should tell you the power that compounding holds.

It isn’t that Warren Buffet never made poor investments or that his returns are astoundingly high, in fact, quite the opposite. Many investors have him beat when it comes to annual returns. Take James Simons, the Quant King himself. He is considered to be among the most successful investors of modern times. In his book The Psychology of Money, Morgan Housel notes that James Simons had a 66% gain in his portfolio annually, compared to Warren Buffet’s 22%! However, when you compare their net worth, it doesn’t add up.

Warren Buffet’s net worth is $117 billion, 4 times that of Simons’ at $29 billion. 

What made the difference? Simons started much later in life, Buffet has spent over 7 decades of his life regularly investing.

At the age of 10, Buffet knew what most investors realise too late – The power of compounding. And now, it’s paying off!

Out of Buffet’s $100 billion net worth, over $80 billion happened in his 50s.

Compounding at play, but, what is it exactly?

What is Compounding?

The act of Compounding is this: Smart choices made regularly for a long time to give successful returns.

 In a finance-oriented context, we could define compounding as the act of investing in an asset regularly and for a long period of time to generate exponential returns.

Most people assume that compounding is just addition. One good choice after another good choice adds up. However, add these choices for a long time and it becomes an exponential equation. How?

Compound Interest

If you were to choose between INR 1 Lakh right now or 1 paisa that gets doubled every day for the next 31 days, which one would you choose?

Hint: That 1 paisa would make you 10 times richer!

Here’s how.

On Day 2, you will have 2 paise. Now, double it.

Day 3, we have 4 paise.

At the end of the first week, we have only reached 64 paise.

10 days – INR 5.12.

15 days – INR 163.84

Things are really starting to exponentiate, we have gone from 5 to 163 in 5 days. And on day 20, we reach INR 10,485.

And the miracle of compounding is that on Day 31, you would be at INR10,737,418.24.

Slow and steady wins again!

What is Compound Interest ?

Unlike simple interest, compound interest doesn’t just pay you interest on the invested amount, but it also couples in the profits. So, you get an interest on the principal amount as well as on the earnings. In a way, compound interest is an interest on your interest.

The following are the factors, which determine how much will your investment compound:

1. The Rate of Interest

The higher the rate of interest, the more the returns. This much is a no-brainer.

However, people often fail to understand that because compounding isn’t a linear addition, but an exponential multiplication, even a slight difference in the interest rate can make a huge difference.

For example, Satish invests in an FD that gives him an annual interest rate of 6.8%.

Mohit invests in bonds and earns an interest rate of 8%.

Let us say they both invested INR 20,000 rupees to begin with.

Satish:

After 5 years – INR 27, 789.85

After 10 years – INR 38,613.80

After 20 years – INR 74,551.27 

Mohit:

After 5 years – INR 29,386.56

After 10 years – INR 43,178.50

After 20 years – INR 93, 219.14 

 Mohit has almost INR 20,000 more than Satish, which is coincidentally the exact money they began with.

2. The Duration of Investment

Charlie Munger, ace investor and Warren Buffet’s partner, says “The first rule of compounding is to never interrupt it unnecessarily.”

The longevity of your investment and its regularity are directly proportional to its returns. 

Let us say, Satish invests INR 20,000 rupees in bonds now, because he knows it offers more than FDs.

He has been investing for 20 years.

Mohit invests in the same bonds at the same rate of interest – assume 8%- for 30 years.

After 20 years, Satish would have INR 93, 219.14. 

After 30 years, Mohit would have INR 201,253. 14.

More than double!

This is what bewilders investors– they can not fathom how 20 years couldn’t make the amount that the next 10 years can. That’s just how compounding escalates.

3. The Principal Amount

The more you start with, the more you can end with.

In the example of 1 paisa that had its value doubled every day, we reached INR 10 lakhs~ in 31 days.

If we had started with a rupee instead of a paisa, which doubles daily, we would have reached INR 10 crore.

Moreover, it’s better to top up the principal amount periodically, thus, adding to the final amount invested. The idea here is to make the principal amount as magnificent as one can – whether in a lump sum or in installments. 

4. The Frequency

It isn’t just how long your investments compound, but how often they compound makes a greater difference.

This, in particular, impacts Annual Percentage Yield, which reflects the actual rate of interest your savings got.

For example, if there is a bond that compounds 6% annually, and there’s another bond that compounds 0.5% monthly, which one do you think benefits you more?

As it happens, with compounding, it is almost always the smaller-looking numbers that are actually bigger. 

The penny one against the million dollars!

0.5% monthly > 6% annually.

Because, if we calculate the annualized return for 0.5% monthly compounding, it comes to 6.17%.

These factors together make an equation that brings the exact amount we can hope to withdraw at the end of our compounding exercise.

However, the simplest route is that of the rule of 72.

What is the Rule of 72?

The Rule of 72 states that if you divide 72 by the annual interest rate, you will get the number of years it will take for your money to double.

So, if your interest rate was 36%, it would take you 2 years to double your money as per the rule of 72. The rule gives the most accurate and optimum results for interest rates from 8-9%.

Please bear in mind that this rule gives near-accurate results, and it is largely in place to do away with complex mathematical functions. You could also replace 72 with 69.3 for even more precision.

Simple Interest vs. Compound Interest: A Comparative Overview

Interest can be calculated in two main ways: simple interest and compound interest. When saving or borrowing money, interest plays a key role in how much you earn or repay. The two primary types—simple interest and compound interest—work very differently. While simple interest grows at a steady pace, compound interest multiplies wealth by earning interest on both principal and accumulated interest. Understanding these differences helps you choose the right option for your goals.

Making Compound Interest Work for You

Stoicism is a factor!

The hare may have been faster, but the tortoise was regular. Unfortunately, many investors would likely jump off the wagon when things go bad. It isn’t difficult to be regular when the rewards are right in front of you, it is scary when you’re in the middle of a recession.

Charlie Munger, Warren Buffet, and Rick Guerin were quite a trio back in the 70s. However, Guerin soon faded away.

In Warren Buffet’s words, “Charlie and I always knew that we would become incredibly wealthy. We were not in a hurry to get wealthy; we knew it would happen. Rick was just as smart as us, but he was in a hurry.”

The stock market plummeted by 65% in 1973-1974, and subsequently, heavy margin loans too quashed Rick’s financial stability.

Guerin had to sell his Berkshire stocks to Buffet at less than $40 a piece, he was in desperate need of money because he had gone too fast and got himself under too much water.

Interestingly, it was the same recession when Munger and Buffet lightened their purses and got more stocks under their portfolio.

A healthy investor neither panics when the market is falling, nor does he jump with excitement and go all in when the market is soaring.

Time is the biggest factor

Patience bears fruits, compounded fruits!

The longer you wait, the more exponentially drastic your returns will be. It isn’t to say that you shouldn’t monitor your portfolio, but do not micro-analyse every change because, until day 15, the doubling paisa was nowhere near a lakh, and on Day 30, it reached INR 10 lakhs. 

Learn when it works against you

The power of compounding isn’t unknown to lenders. They, too, use it. Every time you sign up for a credit card or you apply for a loan, know that compound interest will work against you.

This is why it becomes important to compare Annual Percentage Returns (APR) between two banks and choose the one that compounds less frequently.

Compounding beyond Finance

On an ending note, compounding isn’t just limited to finance. In life too, we compound habits. The day you learned the alphabet was not the day you wrote sentences, and now, you can read, write, and speak in probably multiple languages. That’s compounding.

Frequently Asked Questions

1. What is the difference between simple and compound interest?

Simple interest is calculated only on the original amount (principal). Compound interest, however, is calculated on both the principal and the interest earned in previous periods. This means compound interest grows faster over time. While simple interest yields fixed returns, compound interest accumulates, increasing returns the longer the investment remains untouched.

2. Why is it important to start early with compound interest?

Starting early gives your money more time to grow and accumulate interest. Compounding works best when interest has time to build on past interest. Even small amounts invested early can grow into large sums over decades. For example, investing ₹5,000 monthly from age 25 grows much more than starting the same at 35, even if the total amount invested is the same.

3. What is the Rule of 72, and how is it used in investing?

The Rule of 72 helps estimate how long it will take for an investment to double in value. You divide 72 by the annual interest rate. For example, if your investment earns 8% annually, your money will double in 9 years (72÷8). It's a simple tool to quickly understand how fast your investments can grow under compounding.

4. Can compounding have negative effects, such as on debts?

Yes, compounding can work against you when you borrow money. If you delay credit card or loan repayments, interest is charged not just on the original amount but also on the previous interest. Over time, small unpaid debts can grow into large burdens due to this compounding effect. That’s why paying on time is important.

5. How does compounding work in different investment vehicles like stocks and bonds?

In stocks, compounding happens when you reinvest profits or dividends to buy more shares, which then generate more returns. In bonds, interest earned can be reinvested into new bonds or added to the original bond to increase total returns. In both cases, compounding turns small returns into bigger gains over time.

6. What strategies can help in leveraging compounding for wealth building?

Start investing early, stay consistent, and reinvest earnings. Choose investments that offer regular returns, like dividend-paying stocks or interest-bearing bonds. Avoid interrupting compounding by withdrawing funds too early. Also, increase your investment gradually over time. Even small top-ups can significantly enhance long-term results when compounding is in effect.

7. Are there tools or calculators to visualise the effects of compounding?

Yes, many online tools and mobile apps help you calculate and visualise compound growth. Just input your investment amount, interest rate, and duration. Bondbazaar’s investment calculators can show how much your money can grow over time and compare different options like FDs, bonds, and SIPs.

8. How does reinvesting dividends contribute to compounding growth?

When you reinvest dividends instead of withdrawing them, you buy more units or shares. These new units also earn returns, adding to your total investment. Over time, this creates a compounding effect, on top of returns. Reinvesting dividends is a simple and powerful way to boost long-term wealth.