The Power of Compounding
We all know that it takes money to make money. The principle of compounding simply means that you earn interest on the interest you receive. This would make sense, right? The money that you earned from a investment can grow at an accelerated rate because you are not limited to use the principal amount that you first started with. Thirty percent of $10,000 is way more than thirty percent of $1,000. Obviously.
This concept is important to understand as you begin to realize that this is the reason that you can gain impressive returns over the long run. This is something that honestly should have been taught in high schools, and if you did learn this in school, it probably did not help much since you’re here. This is the first step to learning real-life money management.
Okay. So what is it?
Right. Think of compounding as taking a number and increasing it by a percentage continually adding onto the original number and taking percentage from the new number. Simple interest is the opposite way money grows. This is fixed return (think adding x amount each year – it doesn’t compound) Let us make an example. Say you are receiving $100 interest every year on $1000. This is what it would look:
Year 0 (when you start): 1000
Year 1: 1000 + 100 = 1100
Year 2: 1000 + 100 + 100 = 1200
Year 3: 1000 + 100 + 100 + 100 = 1300
Year 4: 1000 + 100 + 100 + 100 + 100 = 1400
Year 5: 1000 + 100 + 100 + 100 + 100 + 100 = 1500
After five years, the total interest returned is $500.
This is how simple interest works. Compounding, on the other hand, receives interests on the current total number amount. This is what it looks like:
Year 0 (when you start): 1000
Year 1: 1000 + (1000 x 10%) = 1100
Year 2: 1100 + (1100 x 10%) = 1210
Year 3: 1210 + (1210 x 10%) = 1330
Year 4: 1330 + (1330 x 10%) = 1460
Year 5: 1460 + (1460 x 10%) = 1610
After five years, the total interest return is $610. Do you see the difference? When the number is compounded, you end up with more in the end.
Understanding compounding interest come directly from the concept of the time value of money, which states that the value of money changes depending upon when it is received. That basically means $1000 today is more valuable than $1000 next year, because you could have used that money to invest it into stocks and receive interest on it, something you couldn’t do waiting for the money to come. By deferring the money to a later date, the money or resources you miss out on is considered the opportunity cost.
In this picture, you can see that the earlier you compound your money, the faster you will be ahead of returning exponential gains. Time is your friend
Compound returns usually come up when we talk about investing. In this case, you aren’t earning interest, which is a promised, steady amount — you’re potentially earning investing returns, which are definitely not guaranteed and definitely not steady. But they can be super powerful.
There are multitude of ways that investments can make money. When the value of the investment goes up or down, the balance of your account also follows depending on your position. If you net a positive return, those extra funds can have the opportunity to compound over time.
Higher Returns With Higher Risk
Everyone wants to be rich. Some more than other. But one thing is for sure, if there is a possibility to ‘get rich quick,’ there are going to be people jumping on this opportunity without doing much research behind the strategy. Seeing how much you can make with compounding interest, you may want to increase the rate of return to get to your goals quicker. Higher rates of return carry higher risk, but no matter how successful you think you are at a certain point, you want to minimize losses and avoid possibilities of losing more than what you planned for.
Many of the top financial analysts will preach that they have lost way more than was originally planned for chasing for a higher return or yield rate than speculation on a stock. It is important for new investors to resist this temptation and to always stick your plans to reach your goals.