Compounding is the process in which an assets earnings, from either capital gains or interest, are reinvested to generate additional earnings over time. It is the addition of interest to the principal sum of a loan or deposit, where interest is earned on both the principal and accumulated interest. The growth of an asset due to the interest earned on both the principal and accumulated interest is known as compound interest. The compounding frequency is the number of times per year (or another unit of time) the accumulated interest is paid out or credited to the account on a regular basis. The frequency could be yearly, half-yearly, quarterly, monthly, weekly, daily, or continuously. Continuous compounding is the limit as the compounding period approaches zero, and it is sometimes mathematically simpler to use in the valuation of derivatives.

Compounding can occur on investments in which savings grow more quickly or on debt where the amount owed may grow even if payments are being made. It is a powerful investing concept that involves earning returns on both the original investment and on returns received previously. Compounding is a direct realization of the time value of money concept. It is a way to potentially magnify savings over time just by staying invested in the market.

To illustrate how compounding works, suppose $10,000 is held in an account that pays 5% interest annually. After the first year or compounding period, the total in the account has risen to $10,500, a simple reflection of $500 in interest being added to the $10,000 principal. In year two, the account realizes 5% growth on both the original principal and the $500 of first-year interest, resulting in a second-year gain of $525.

Overall, compounding is a powerful tool for growing wealth over time, and it is important to understand how it works when making investment decisions.