In the world of investments, compounding refers to the ability of an asset to generate returns, and then again generate returns on the original investment as well as on the return from the previous period.

When this goes on for a long period of time, in later periods the original investment grows exponentially and the total corpus becomes multiple times the initial amount.

How does it work?

You invest some money (principal), which earns interest at a certain rate (%) at the end of the first period (yearly, half-yearly, quarterly or monthly). At the end of the second period, a larger block (principal + interest) earns interest: The principal earns interest and along with it, this time, the interest you earned at the end of the first period also earns interest. The total sum that earns interest in the third period is even bigger and, as the process continues, the block of money gets larger.

You can witness this power of compounding in systematic investment plans (SIPs) of mutual funds.