Compounding is the concept of earning return on both your principle investment and your profit. It is a way of calculating return that assumes you pull back your return till yesterday and remain invested so that any change in value today will reflect not only in your original investment but also in your return so far.
For example, let’s say you own 100 shares of XYZ Ltd at Rs 10 each. A day after buying them the price rises 2% to Rs 10.2. On day 2 the price rises another 2%, your investment now will not just add another Rs 0.2, but thanks to compounding your value will rise to Rs 10.44. What you need to understand is that compounding values of assets is not a straight-line graph or linear progression. Rather, changes both positive and negative get compounded and your returns are exponential. If you choose good quality assets, your returns can get positively compounded multiple times of your original investment and the opposite happens if you are not careful about the quality of the asset you choose.