The Important 1 Power of Compounding with examples

Power of Compounding 

Compounding is a concept that refers to the exponential growth of an investment over time. Compounded interest means the interest on interest. Every time you earn interest on your principal, it gets added to your original principal amount. So the next time you earn the interest on the increased principal amount. Over time, this allows your interest to grow drastically. The idea is that, by reinvesting the returns earned on an initial investment, the value of the investment can grow exponentially over time. The longer the investment is allowed to compound, the greater the growth will be.

The power of compounding can be illustrated through examples. Suppose an investor puts $10,000 into an investment that earns 5% per year. After one year, the investment would be worth $10,500. If the investor reinvested the $500 in returns earned that year, the new total would be $11,025. After two years, the investment would be worth $11,576.25, which is more than $50 more than if the investor had simply left the original $10,000 in the investment without reinvesting the returns.

Now let’s take a longer-term example. Suppose an investor puts $10,000 into an investment that earns 8% per year, and reinvests all the returns. After 20 years, the investment would be worth $46,610. This means the original investment has more than quadrupled in value over the 20-year period.

But the real power of compounding comes into play when the investment is allowed to compound over a longer time horizon. If the investor had left the $10,000 investment alone for 40 years, it would have grown to $217,484. This means the original investment has grown more than 20 times in value.

Another important point to note is that compounding works not only for investments, but also for savings. Consider the case of an individual who starts saving $500 per month at age 25 and continues to save that amount every month until age 65. Assuming an average annual return of 8%, the individual would have accumulated approximately $1.2 million by age 65.

Following can be the factors which may affect power of compounding:

1.      Reinvestment – The compounding will only matter if you reinvest your returns like dividend or interest income. Compounding won’t have any role just on the principal component.

2.      Rate of Interest – The rate of interest used to compound your investments must be able to cover the inflation rate of the economy. It also depends on the type of instruments you invest in.

3.      Selection of Instruments – The instruments you invest in should be able to generate a consistent return over a period of investment. Also, equity is more likely to compound itself than the debt. The principal of higher the risk, higher the reward applies here.

4.      Time period – The true potential of compounding can only be seen when the investment is for long term, rather than short term.

5.      Cost of investment – Higher the cost of maintaining your investments, the lower the results of compounding.

6.      Inflation – Inflation also experiences the power of compounding, a 7% inflation means you will have to pay 175% more for the same expense in 15 years.

7.      Repayment of debts – Non repayment of debt on time will also attract compound interest on your borrowings which can offset the compounding on your income. Remember to pay your debts on time to avoid this.

8.      Tax Rate – The tax rate plays an important role in financial planning. Higher taxation on long term gains will severely affect the power of compounding.

In conclusion, the power of compounding is one of the most important concepts in finance. By reinvesting returns earned on an initial investment, investors can grow their wealth exponentially over time. Even small investments made early on can lead to significant wealth accumulation over the long term.