Compounding Interests in investments is one of the most important principles in Investing. If in doubt, check out Warren Buffet’s portfolio. His life is practically a case study of compounding interests, and he attributes his success to understanding this principle at a young age and started investing at 9 years old.
What does compounding interests mean?
Compounding interests is the process where an asset’s earnings from interests, dividends, capital gains, are reinvested to create additional earnings over time. This compounding creates exponential growth as the investment will generate interests from not just the Capital, but also from its accumulated and reinvested earnings.
Simply put, compounding interests in investments means re-investing your profits (earned interest) back into the principal (Capital) of an investment. As you reinvest interest upon interest, your investments can grow exponentially. This is the result of letting your investment compound over time. With a little bit of interest and a lot of time, compound interest can help grow your investment portfolio significantly.
Why you should practice the principle of Compounding Interests
Compounding interests can have a significant impact on an investment’s value when it takes place over time. The principle behind compounding interests is simple: it compounds or multiplies one amount repeatedly into a higher amount until the desired investment portfolio is achieved.
The larger amount you invest, the larger interest it will generate, which can now increase additional interest over time. Allowing the interest earned to compound for a while is important to see the exponential growth in earnings. In the world of compounding interests, the most important factor is time.
Example: Suppose there are two investors who have a starting balance of $10,000 dollars each and they both decide to buy the same investment on the same date, and they plan to hold their investment for 30 years. If one investor plans to withdraw their interests at the end of each year, while the other plans to compound their interest for 30 years, at the end of the 30 years, if the investment earned 7% per year, the investor withdrawing his interest would have earned 700% per year while the investor who compounds his income would have earned $21,000 over the years on the Capital alone. The investor who compounded his investments would have earned $76,123 from reinvesting his interest. This is known as dividends. This illustrates the importance of Compounding Interests.
The strongest force in the universe is compound interest. He who doesn’t understand it pays it, he who understands it earns it.
Some of the best investments you can make are those that have a compounding effect. These types of investments generate returns that compound at a higher rate, meaning they grow in value over time and will be more valuable than when initially invested.
The Importance of Time in Compounding Interests
More time = more money
Time is everything in compounding interests and that is why you should start investing at a young age. The important step is to begin as early as possible.
At the age of 90, Warren Buffet has amassed a net worth of over 100 billion dollars. Interestingly, over 90% of his net worth came after the age of 55. A study of his investment portfolio over the years shows that his earnings increased exponentially after the age of 55, with the most significant gains in the later years. Remember that he started investing at 9. Time profoundly impacts the results that would be gotten from compounding. Compounding Interests over a long period of time can potentially lead to significant growth of an investment portfolio. As time goes on, your earnings will continue to grow as a result of the principle of compounding interests.
The compounding effect is a good reason to start investing early in your career. The longer you invest, the more profitable it becomes. In fact, if you invested $1 when you were 18 and made 1% a year on that investment until now at age 22, then your account would be worth over $20k!
4 Ways to Harness the Power of Compounding Interests
- Start investing early: The earlier you start, the earlier you can start taking advantage of the power of compounding.
- Reinvesting your earnings: Earnings are usually in the form of Capital gains and dividends. Some brokers may allow you to automatically reinvest these earnings, or you can buy a different investment.
- Avoid taking excessive risks that can lead to large losses: This is one of the biggest obstacles that many investors face. Compounding only works if you are earning on your investment. Of course, always earning a profit is easier said than done, because investments sometimes make money and sometimes lose money. You can’t guarantee that your investments will make money, but you can avoid taking huge risks that may lead to large losses. Diversify your portfolio across different assets classes and diversify your portfolio within each asset class. However, asset allocation and diversification do not eliminate the risk of loss. To avoid large losses, resist the temptation of taking excessive risks of not taking risks and staying on the sidelines. When it comes to compounding investments, not investing can occasion a potentially huge risk.
- Beat Inflation by Investing in Productive Assets: This means investing in a portfolio with the ability to generate profit and cash flow, such as a business, farm or real estate.
This means investing in high-quality companies that consistently increase their dividend payouts over long periods of time. These companies are Cocacola, 3M, Proctor and Gamble, Apple, Microsoft etc. This strategy provides the ability to create cash flow without selling your position in a stock. This strategy creates a large compounding effect when dividends are being reinvested and creates a snowball effect that compounds over time. This is why dividend investing is the best investment strategy.
Why people don’t take advantage of Compounding Interests
Not many people take advantage of this tool because it requires basic knowledge and understanding which helps us understand how investing works properly.
The best way to take advantage of Compounding interests is by starting early with investments like stocks or bonds so that they can grow as quickly as possible without any hassle.
Why Compound Interests is such an Important Concept for Investors
Compounding interests is a concept that is important to understand for people who are investing in any kind of investment funds. The effect of compounding on leveraged funds, like stocks and bonds, is significantly magnified because the principal amount grows exponentially over time.
Over time, compound interest can significantly impact your wealth and make you a financial wizard. However, most of us are not financial wizards so it’s important to have some basic understanding of how compounding works as well as the average rates for different types of investments.
Compound interest is the process of earning interest on your investments that are already in place. The longer you can compound, the greater your results will be.
If you start early, invest consistently, and stay invested for the longest time possible, the compound will help build wealth and grow. The compounding effect can help build wealth and grow. There you have it – Start early, invest consistently, and stay invested for the longest time possible
Read More: How to Invest your first $1000