Understand Compounding on Your Investments
There isn’t a much more important basic financial concept to understand when it comes to investing. The compounding principle is basic and easy to understand, but far too often overlooked. It is the single largest factor in amassing a lot of money over a long period of time. Here we’ll cover how it works and how you can use it to greatly increase your investment accounts over long periods.
How does compounding work?
Compounding refers to how an investment grows over time based on returns on the original investment and then returns on the returns of the investment. Each period that you invest your money, assuming a constant return, you will earn more and more money, and your initial investment will grow quicker and quicker, accelerating the longer you stay invested. Here’s an example:
Let’s say you invest $10,000 today and you earn a 10% return for the life of your investment. In the first year, your investment grows by 10% to $11,000 and you’ve earned $1,000. In year two, instead of growing by $1,000, it grows by $1,100 ($11,000 x 10%) to $12,100. In the third year it grows by $1,200 to $13,300. Note that the growth in year three is already $200 more than in year one. Amazingly, by year ten, your $10,000 investment is worth $26,000 and by year twenty it is worth $67,200. An in 30 years, that same $10,000 is worth $174,500 and is growing by $17,500 per year. Note that the growth after twenty five years is more each year than the initial investment.
How can compounding make you rich?
As the previous illustration shows, the longer your money compounds, the faster your annual returns grow. It is somewhat of an exponential growth, because each year you are earning the same percent on a larger investment. Now the question is, how can you use this basic financial concept to your advantage. The answer is easy. Start investing today and let your money grow for as long as you can. For a dollar invested today is worth multiples of itself years from now.
Recognize how compounding works and it should give you extra motivation to invest and keep investing. Subsidize your returns by adding more money to your investing accounts whenever you can. Use the other advice we provide to find hundreds of ways to maximize your savings and your returns.
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