Introduction
Do you know the concept of compounding in investment? It is the process of accumulating interest overtime to earn more interest. Compound interest is calculated not only on the initial principal but also on the accumulated interest of prior periods. This means that compounding is the accumulation of a growth rate over time and it is the opposite of discounting.
{tocify} {$title=Table of Contents}
Definition
Compounding is the process of reinvesting returns from an asset to generate extra earnings over time. It involves earning returns on both the original investment and on returns received before.
How Does Compounding Work?
Suppose you have USD$100 and you decide to place it into a bank account paying 5% interest annually, at the end of the year, you will have USD$105. If you save it for another year, the future value will be USD$110.25 (USD$105 plus another 5% interest). If you invest USD$100 at an interest rate of 5% per year for 10 years, the future value of USD$100 will be 1.05^10 multiplied by USD$100, which is USD$163.
The Rule of 70
The ‘Rule of 70’ in the economy states that if incomes grow at 1% per year, it will take about 70 years for incomes to double (70/1). But, if incomes grow at 3% per year, it will take about 70/3 or 23 years for incomes to double.
The Secrets of Compounding
The power of compounding is the reason why it is so important to begin investing when you are young. Even growth rates that seem small when written in percentage terms seem large after they are compounded for many years. Given enough time, even modest investment returns can generate real wealth.
Real-Life Stories about Compounding
Warren Buffet and Benjamin Franklin are two examples of the real-life impact of compounding in investment.
Story 1: Warren Buffet
Warren Buffet recognized the power of compounding when he was ten years old, and it has guided his decisions ever since. In a recent Warren Buffett biography, it was said that Buffet could picture the numbers compounding as vividly as the way a snowball grew when he rolled it across the lawn. Buffet began to think about time in a different way and saw compounding as a way of marrying the present to the future.
Story 2: Benjamin Franklin
Benjamin Franklin left the equivalent of USD$4,400 to each of two cities, Boston and Philadelphia when he died in 1790. The gift came with strings attached, the money had to be loaned out to young married couples at 5% interest, and the cities could not access the funds until 1990. Two hundred years later, Franklin’s USD$8,800 bequest had grown to more than USD$6,500,000 between the two cities!
Compound Interest Calculator
Conclusion
Compounding is a powerful tool for maximizing your returns on investment. It is the accumulation of a growth rate over time, which means even modest investment returns can generate real wealth given enough time. The power of compounding is the reason why it is so important to begin investing when you are young. Two real-life stories about compounding, Warren Buffet, and Benjamin Franklin, show the real-life impact of compounding in investment.
Was this helpful?
0 / 0