What is compounding?
Compounding is an essential part of investing. Compounding refers to investment returns generated on the returns you have already earned. Compounding can thus be construed as interest on interest—the effect of which is to magnify returns to interest over time, the so-called “miracle of compounding.”
Picture this: A snowball rolling down a hill; it may start small, but it grows the longer it rolls, adding layer upon layer. The snowball represents your balance, and the layers represent the compounding returns. The compound returns are based on your entire account balance.
How does it work?
To illustrate how compounding works, suppose $10,000 is held in an account that pays 5% interest annually. After the first year or compounding period, the total in the account has risen to $10,500, a simple reflection of $500 in interest being added to the $10,000 principal amount. In the second year, the account realizes the 5% growth on both the original principal and the $500 of first-year interest, resulting in a second-year gain of $525 and a balance of $11,025. After 10 years, assuming no withdrawals and a steady 5% interest rate, the account would grow to $16,288.95.
Simply put, compounding is a key driver of wealth creation, and its effects are paramount in several long-term investment strategies. If you decide to keep your money under your mattress or in your bank account earning interest at around 1-2%, it will take significantly longer to build your wealth and you will not be putting your money to use in the most effective way.
So, what can we do? We use the compound interest method where we invest a small amount of money that is comfortable enough for you to start with, and over time, your wealth will accumulate faster.