Compounding is the term used to describe how an asset’s value grows as a result of the interest that is earned on both the principal and the accumulated interest. Compound interest is another name for this phenomenon, which is a direct application of the time value of money (TMV) idea.
Compounding is important in finance, and many investing techniques are driven by the profits associated with its effects. For instance, many businesses provide dividend reinvestment programs (DRIPs), which let investors use their cash dividends to buy more shares of stock. Reinvesting in more of these dividend-paying shares increases investor returns because, assuming constant dividends, the increasing share count will steadily boost future dividend payout income.
This approach, which some investors refer to as double compounding, adds another layer of compounding by investing in dividend growth equities on top of reinvesting dividends. These dividend growth stocks are boosting their per-share payouts in addition to reinvested dividends that were previously used to purchase additional shares.
Assets and obligations are both subject to compound interest. Compounding increases an asset’s worth more quickly, but it can also raise the amount owing on a loan — because interest accrues on both the principal balance and prior interest fees. Even if you make loan payments, compound interest may cause your overall debt to increase in subsequent months.
The power of compounding works by growing your wealth exponentially. It adds the profit earned back to the principal amount and then reinvests the entire sum to accelerate the profit-earning process. Suppose, you invest Rs 1000 in a bank that offers 10% interest per annum, then your investment becomes Rs 1100 after the first year, then Rs 1210 after the second year, and so on.
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