To illustrate the point, you invest $100 at the rate of 10% per annum. At the end of the year, you earn an interest of $10 on the principal amount of $100. Next year the interest of $10 is added to the first principal and the new principal for the next year becomes $110. So you invest $110 at rate of 10% for the next year. The process of adding the interest to the principal thus goes on year after year.

This kind of compounding is a very powerful tool in multiplying the investments and getting increased returns.

At first sight an addition of mere $10 to your principal amount appears rather small and not worth any consideration. Even if you try to calculate the compounded interest, say, for 3/4years, the gain in terms of capital formation may not appear to be very significant.

This, however, is a simplistic and fallacious view. If you wait patiently for some time, even a small rate of interest compounded over time makes a huge difference. The benefit that you receive arises primarily from the fact that your income from interest keeps increasing your principal which, in turn, generates higher returns. In course of time, the principal amount grows in geometrical proportions.

The table below illustrates how a small amount of, say, $100 at the rate of return of 5% can grow with the power of compounding:

At end of year5%

1$105

5$128

10$163

15$208

25$339

It must, however, be borne in mind that the real magic wand in multiplying your wealth lies with the Time factor. You have to be patient.

Albert Einstein, the great scientist, called compounding a great discovery of mathematics of all time.

Benjamin Franklin termed compounding as the eighth wonder of the world. He once wrote ?: "'tis the stone that will turn all your lead into gold. Remember that money is of a prolific, generating nature. Money can beget money, and its offspring can beget more."

Such is the magic of compounding.

The question now is how to bring the time factor to your side? This can be done only if you start investing as early as possible after you become an adult in the state of your residence. You must have the social security number and the IRS identification number to pay taxes as well.

Let us assume a person starts investing at the age of 20. He invests $1,000 per year for 10 years in a portfolio that earns an interest rate of 5.5% per annum. After that he stops contributing and let the investment grow at its own pace. By the time he pasts 60, his capital grows to more than $75,000. It is a big amount to receive when he retires.

Now suppose another person starts investing at the age of 45 years. In order to make the same amount that the first person could make when he started at 20, he will have to invest around $1700 per year for around two decades to catch up with the early bird. The former not only earns money on his initial investment, but in the coming years earns money on previous years? earning also.

The principle of compounding can turn even your small investments into whopping amounts after a period of time. Compounding has a multiplier impact since the interest earns interest by becoming a part of the principal. The amount grows at geometrical rather than arithmetical progression. The higher the rate of return, the steeper becomes the curve.

Compounding, basically, is a long term strategy. Suppose you invest in ETFs and start investing a part of your income regularly, the growth of your money can be phenomenal. You can also instruct your stock broker to reinvest your dividend regularly through DRIPs. There are brokerage firms that do not charge you any commission under DRIP. The process becomes automatic without your knowing any thing about it, till one fine morning you find your investments have grown beyond your wildest expectations.

To summarize, there are three ways to put compounding to work for you.

1. You should reinvest your dividends.

2. You should invest a part of your income regularly.

3. Wait patiently. The longer you allow your money to work, the more returns it will yield.