Compounding is more than maths

Recently, a reader sent me a thoughtful criticism I'd like to share: "Please stop using the term 'compounding' when it pertains to market investments like equity. 'Compounding' implies a rate of interest that ensures that the investment will grow at a fixed rate YoY. There is no such assurance in the market; your investments may grow by 5 per cent, 10 per cent or even lose 5 per cent. Calling this a 'compounding' effect is misleading the reader."

The reader affirmed their belief that market investments are indeed the best hedge against inflation but maintained that 'compounding' remains a deeply misleading term that confuses new investors and does them a disservice.

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I appreciate this feedback, as it highlights an interesting tension between academic precision and practical understanding in personal finance. However, I respectfully disagree with this rigid, textbook interpretation of compounding.

In practical finance - the kind that helps people build wealth - we use "compounding" to describe returns that stay invested and thus enhance future returns. When I invest in a mutual fund and allow the money to remain invested, the returns increase the value of my holdings. Further returns accrue on that increased amount. That's a perfectly reasonable definition of compounding for everyday personal finance.

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The purpose of personal finance terminology isn't to satisfy academic purists but to explain concepts in a way that helps people understand and make decisions that produce good outcomes. Overly rigid textbook definitions can remain confined to textbooks while the rest of us focus on building wealth in the real world.

We should expand our understanding of compounding beyond finance. Consider a company that's steadily growing its business. Isn't this growth an example of compounding? It is. Each growth phase builds upon previous achievements in financing, product quality, marketing, sales, distribution, and countless other aspects. Today's success becomes the foundation for tomorrow's greater success.

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This is what compounding truly represents, whether in business, investing, or other facets of life. It's about the snowball effect - how small advantages accumulate over time to create disproportionate results.

History's greatest investors didn't achieve their remarkable success by adhering to narrow technical definitions. Instead, they grasped the practical reality that compounding works in business value as it does in a fixed deposit, albeit with less predictability and more potential.

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The variability of returns in equity markets doesn't negate the compounding effect - it simply makes it less straightforward to calculate. A business that grows its earnings by varying percentages yearly still compounds its value. An investment that delivers uneven returns still benefits from the mathematical reality that Rs 100, increasing to Rs 110 and then to Rs 125, represents compounding in action, regardless of whether the growth rate was consistent.

The most important aspect of compounding in investing isn't the mathematical precision of the returns but the behaviour that makes it possible. The discipline to stay invested, reinvest gains rather than spending them and think in decades rather than days enables the magic of compounding to work in our favour.

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Too often, investors become fixated on semantics and technicalities while missing the forest for the trees. The reader is correct that market investments don't guarantee fixed annual growth rates. However, while accurate, that observation misses the larger point about how wealth actually builds over time.

For the average investor, understanding that returns on returns create accelerating growth is far more valuable than quibbling over whether this phenomenon strictly meets a textbook definition of compounding. The goal is financial wisdom, not terminological purity.

So, I'll continue using "compounding" to describe the powerful force that turns modest investments into significant wealth over time because it effectively communicates an essential truth: in investing, time is your greatest ally, and patience is your most valuable virtue.

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