*What is Compounding Trading? Meaning, Rules & Benefits Explained...* Compounding is often called the eighth wonder of the world. Albert Einstein dubbed it as the most powerful force in the universe. “He who understands it, earns it. He who doesn’t, pays it”, the scientist is reported to have said. So, what is compounding and why should you care about it? What is Compounding Trading? The concept of compounding draws from what is called compound interest. Most of us will be familiar with simple interest and compound interest, which we learnt in school. The formula for simple interest is this: i (Interest) = p (principal) x (return) x t (time). Meaning if you invest Rs 10,000 in an FD yielding 10% for a period of 1 year, your interest (i) = 10,000 x 10/100 x 1 = Rs 1,000. Now when you get 10% on your FD investment, you have two choices, withdraw that Rs 1,000 or let it continue as part of your investment. This means that next year, you will either again earn Rs 1,000 if you withdrew your interest amount, or Rs 1,100 (10% of the revised investment amount of Rs 11,000). The fact that in the second option you earn interest on interest is called compound interest. It has a slightly complicated formula, which, if you didn’t like maths in school, you will not want to look at right now, but we can leave that aside because we have understood what we mean by compound interest, which is to let your money grow by allowing your returns to remain there. Rules you Need to Remember While Compounding Trading. The first one is quite straight forward. The power of compounding becomes stronger over time. That is, if you invest Rs 10,000, and your returns were 10%, you will earn Rs 1,000. Now if you allowed this Rs 10,000 (and the compound interest it kept generating) to remain invested, it will have grown to about Rs 1.75 lakh in 30 years. What does this mean? To allow an investment to compound over time, you should start early. For example, if you invest Rs 10,000 every month starting age 25, at age 60, you will have invested Rs 42 lakh in total spread over 420 months. Assuming returns of 10%, your money will have grown to about Rs 3.79 crore. But if your friend started at age 35 and start invested Rs 20,000 every month to make up for his late start, he will have invested Rs 60 lakh in total but will still end up with only Rs 2.65 crore 25 years later. What happened here? By starting late, your friend deprived himself of the 10 last years where the effect of compounding was expected to show up the most. There is rule number two. Small differences in the rate of compounding can produce large differences in return over the long term. Imagine your parents had invested in a house in the ‘80s for Rs 1 lakh and it has since grown to about Rs 1 crore in 40 years. That’s an annualised growth rate of 12.2%. Pretty impressive, right? 100x growth in 40 years. But what if that money was invested in the Sensex instead at 15% instead of 12.2%? What difference does the 3% make over the long term? The amount today would have been Rs 2.67 crore! So basically, start early, remain invested and get as much returns as you can, and you will get super rich? This sounds interesting: you can start investing early in stocks, which tend to give better returns than most other asset classes over time. But hold on. While you will have understood the concept of compound interest when it comes to fixed-return instruments like FDs, how does compounding work in the context of stocks? Basically, when you hold a stock for a long time, you automatically get the benefit of compounding. *How so?* Whenever a company makes a profit, say Rs 100 crore at the end of the year, it will give some money back to the shareholders (say Rs 20 crore) to its shareholders by way of dividends while reinvesting the rest (Rs 80 crore) into its business. The future business of the company now grows at a faster pace because of the increased capital that was reinvested, which is nothing but compounding at work. Since share prices mirror earnings growth over the long term, it translates into higher growth for stocks. So let me bring in some trivia here. If you followed the above point: when a company, which has been growing at 15%, pays you a dividend, should you feel good about it? If you receive the dividend and invest in an option that will return less than 15%, you are worse off! There is one final rule that you need to keep in mind when it comes to compounding. Most people, even trained mathematicians, will find it difficult to predict how much an amount will grow to if the time is long enough and the return is high enough. Almost always, you will be conservative in your calculations. This means, that if a stock portfolio returns 14%, you may not think it’s not a big deal but over a period of 30 years, it is. If you can manage 18%, you will become rich. If you can grow your capital at 24%? That’s the same math Ramesh Damani used in this YouTube video to calculate that you will make Rs 100 crore! This means that those who come to the market thinking they want to earn 10% every month, remember that it’s a pipe dream to consistently do it. If you did, you will soon end up being richer.