What It Means
Compounding is what happens when the returns your investment earns start earning returns of their own. Instead of growth staying flat year after year, it accelerates, because each year's gain becomes part of the base the next year's gain is calculated on.
How It Works
Simple interest pays you a return only on your original amount, every year, forever. Compound interest pays you a return on your original amount plus every return you've already earned. That difference sounds small on paper and turns out to be enormous over time, because the base you're earning on keeps growing instead of staying fixed.
Most Indian mutual funds and SIPs compound in practice even though nobody sends you an interest payment: the fund's value simply grows, and next year's growth is calculated on this year's already-grown value. The more compounding periods (and the longer you stay invested), the bigger the gap between compound growth and simple, flat growth becomes.
Example
Put ₹1,00,000 into an investment earning 12% a year, compounded annually. After 5 years it's worth about ₹1,76,234. Leave it for 10 years instead of 5, and it's worth about ₹3,10,585, more than 3x the original amount, and more than double what 5 years produced, even though the time only doubled. That gap between "double the time" and "double the money" is compounding doing its job.
Warning
The most common mistake is assuming growth scales in a straight line, that doubling how long you stay invested simply doubles what you end up with. It doesn't, because the extra time also compounds on the gains you already made, not just on your original contribution.
Common Variants
- Annual compounding: returns are added to the base once a year (the common way lumpsum growth is illustrated).
- Monthly compounding: returns are added to the base every month (closer to how a SIP's underlying fund actually behaves, since money goes in and grows continuously).
- Simple interest: the non-compounding version, a return calculated only on the original amount, every period, with no acceleration.