Cryptocurrency might change the way our economies work and become a new foundation for future financial systems. This is far from being a fact at this point, but the disruptive potential is definitely there. E-cash might not end up being the paradigm shift many think it to be, but that is no reason to underestimate the change.

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There are many ways to earn more money with less effort, but one of the simplest and most convenient is through compounding.

According to Albert Einstein, “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”

Compounding is the process of reinvesting earnings from capital gains or interest to generate additional earnings over time. It has the potential to exponentially grow your capital by creating a chain reaction of returns from the returns invested in the financial instrument.

Defining the Compounding Rate Parameters

• Compounding Rate – The concept of compounding is both simple and potent, owing to its ability to multiply returns. It allows investors to earn not only on their initial investment but also on the accumulated interest over time.
• Time Period – When utilizing the power of compounding to grow one’s capital, it is advisable to maintain uninterrupted investments to maximize the growth potential of the compounding rate.

Benefits of Compounding

The compounding strategy demands two essential components – investment earnings and time. This investment approach is typically designed for the long-term. When you opt for reinvesting the interest earned, you create an additional source of income, allowing you to generate returns from the interest earned. Consequently, your investments turn into an income-generating resource, where your money works to produce wealth on your behalf. This is the key advantage of compounding; if invested wisely, it can assist in creating massive wealth.

How does compounding work?
Let’s consider an example to understand how compounding functions. Suppose you invest Rs. 20,000 in a scheme that offers a 5% annual interest payout.

At the end of the first compounding period (i.e., one year), your total savings account balance would increase to Rs. 21,000. This is because the interest of Rs. 1,000 (5% of Rs. 20,000) is added to the principal amount. Compound interest becomes effective only after the first year since it generates interest that can be reinvested in the market.

After the second compounding year, the enhanced principal of Rs. 21,000 experiences a growth of 5%, resulting in an overall gain of Rs. 1,050. Consequently, your balance becomes Rs. 22,050. In this case, both the principal amount and the interest earned have increased due to compounding.

How does compounding work in the stock market?

Compounding in the stock market can be more complicated than the fixed returns offered by a bank deposit. Rather than a fixed return, the compounding effect in the stock market comes from the increasing value of the shares you hold.

For instance, let’s consider a scenario where you invest Rs. 20,000 in Company A. In the first year, the value of your shares rises by 5% to Rs. 21,000. However, the real impact of compounding will only be apparent from the second year onward.

Assuming the value of your shares once again rises by 5% in the second year, the value of your holdings will increase to Rs. 22,050. However, it is important to bear in mind that the stock market is inherently risky, and the value of your holdings may also decrease, leading to potential losses.