Investing is by no means an easy task and it is one that involves many stressful ups and an downs. For the average non professional investor, these ups and downs can be overwhelming, while the professional sees them as just daily market volatility. So, no matter what you do as an investor, you will see your investments raise in price and go lower in price. There just isn’t any way to avoid market volatility as an investor. But, what we can do as investors is to work on a very important cornerstone of investing, and that is compounding.
Compounding is most often described as “compound interest” (Wikipedia and compound interest), other people simply describe it as compounding.
What is compound interest?
Simply put, compound interest is a process where an investor can earn interest at an increasing rate as the cash returned from the investment is reinvested back into the investment portfolio. Let’s look at an example:
Initial Capital = $100
Interest Rate = 5%
Interest after 1 year = $5
Total Capital after 1 year is $105
Here is the compounding part so watch closely !!! As you see below the interest for the second year is off a newly higher base of $105 dollars.
Capital at beginning of year 2 = 105
Interest Rate = 5% (unchanged)
Interest for year 2 = $5.25
Total capital after year 2 = 110.25
So, the extra boost from compounding is $.25. Yes, yes, I know compounding isn’t a get rich quick gimmick…nor is it a bitcoin strategy. Instead compounding is a slow and methodical way to boost your investments over time. The example I used is very simple and using small numbers. But when extrapolated over 10-20 years the true power of compounding can be shown. You can jump over to Investor.gov to see their compounding calculator.
I just did a quick compounding of
Initial investment of $100,000, @5%interest, and $100 month contribution, for 20 years. and the total grows to $305,009. There are a number of variables at work here, so you can jump over there to run your own example. But the important concept here to take away is to fully understand that you want the base of your investments to grow over time, and to grow and an increasing rate. If you were to not add the $100 contribution each month, and you removed the 5% interest each period to spend it, then you’d still just have $100k at the end of 20 years.
The point here is to put your money to work, and then allow it go grow upon itself to boost the value of your portfolio. As you can see above, this won’t happen over night, but instead in a consistent and steady way.