What are the pros and cons to watch out for while planning to go for compounding? Arun Kumar answers

economictimes.indiatimes.com:

«Broad idea is very slow and then all of a sudden it starts making meaningful jump. So, in a crux that is how compounding kind of gets it powerful in the longer run,» says Arun Kumar, FundsIndia.com.When it comes to the word compounding, in Latin terms it means put together. In a financial sense, we have seen wonders happening. But at what point in time, would just want to know that how early one should start focussing on compounding and then probably what sort of wonders that you have seen over the years, share some of your experience on that front.The broad idea of compounding is fairly simple.

Instead of a theoretical explanation, let us say you are making 10% over seven years, how much do you make? Now most of us do the math saying 10% into seven, so it should probably be 70%. Now, in reality you actually make 95%. Now, where is this 25% coming in? That is what people refer to as compounding.

Now, what it does is very simple. Let us say you have 100 bucks and then there is 10% on it. First year you make 10% on 100 which is Rs 10.

Now, mentally we think the second year also it will be the same 10 but we forget that the Rs 10 also gets added to your base and now your base is 110, so the same 10% return is now able to provide you Rs 11 instead of 10 and eventually the next year it is probably at 121 as a base you make Rs 12. So, eventually this gets added and that is how you see that extra 25 that I was talking. So, net-net the broad idea of compounding is that initially it is your original amount that takes the load but over a period of time your returns also provide an additional amount which gets added to your base and the same 10% say on one lakh is very different from 10 lakhs.