What is Compounding?

Compounding, is a process where the value of an investment or in this case, the value of invested stocks increases because the earnings of the investment, both capital gains and interest, earn interest as time passes.

The meaning of the term Compounding in the stock and business world is not that complex, if I do say so myself. One thing I’ve realized is that a lot of people get scared away by the use of complex words when defining business terms so I’ll try as much as I can to be as simple enough.

Compounding, is a process where the value of an investment or in this case, the value of invested stocks increases because the earnings of the investment, both capital gains and interest, earn interest as time passes. The type of growth here is usually an exponential increase and it arises due to the earning of interest on both principal and accumulated interest over time.

Still confused? I’ll explain better; Compounding in stocks occurs when your investment earnings interest which we know as dividends is added to your capital, which is what you used to invest in the first place and reinvested to earn profit after a period of time. This forms a rather larger base on which future earnings may be accumulated.

So look at it this way. The dividends you get from investing in stocks is added to your capital and used altogether to invest in more stocks. Therefore, you now have a larger investment base which has the potential to give you even larger profits, and the longer your money is invested, the more you stand to earn or gain even more from compounding.

Still confused? Let me give an example;

An investor invests N50,000 in stocks and earns about 12% annually. He now reinvests all his earnings into stocks again. Calculate his compound profit and you’ll see that the profit he would be enjoying after 10 years would be enormous. I hope you’re clear now on compounding in regards to stocks? Good to know.