Finance and The Power of Compounding

The simplest and most powerful tool to understand when investing is the power of compounding. This is such a strong method that even Einstein called it the greatest mathematical discovery of all time. I tend to agree because unlike calculus, everybody can get, and regularly use this concept.

For compounding to work only two things are required. Firstly, it is the reinvestment of earnings and secondly it is time. The longer you give your investments the more powerful this tool becomes. This is much easier to understand with an example.

Lets say you invested $10,000 which earned 6% annually. This amount comes to $600 after one year. Now if you didn’t take out your interest earnings and reinvested that amount then in the next year you will earn $636 as interest income. That extra $36 comes from the fact that you had reinvested. Sure, this sounds like peanuts right now but consider the fact that if you save $10,000 in your mid twenties and forgot about it, (meaning you kept reinvesting the interest) then forty years later that $10,000 would become $109,028 and some cents. Whereas if you had kept taking your measly $600 out every year, then you would still have just $10,000 and have taken out a total of $24,000 during those 40 years. So the difference in earning becomes as big as $75,000 and some change! That is no longer peanuts by any standard and will go far to help you live comfortably in your retirement years.

This calculation has ofcourse taken in to consideration that fact that the interest is compounded annually. If the interest is compounded more frequently, then the amount earned would be larger.

The key thing here is that you have given your money time to grow. Lets take another example where two people invest the same amount of money but at a different stage in their lives.

Sally invests $15,000 when she turns 25 and is earning an annual rate of interest of 5.5%. James does the same but when he turns 35. When they both turn 50 Sally has $23,713.74 more than James. That is because Sally earned $47,200.89 and James earned $23,487.15. So Sally has already earned more than double of what James has earned and they are not even at retiring age yet.

In another 10 years Sally will have nearly $100,000 in her bank account while James will have nearly $60,000 giving Sally a cool extra $40,000 to live her golden years with. The longer we give compounding investments a chance, the more they return us in dividends.