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Compound Interest

The Power of Compound Interest

Compound interest is fundamental for long term success for investors and traders.  According to various sources, Albert Einstein stated that compound interest is "the greatest mathematical discovery of all time."  He is also attributed to have claimed that compounding is the eighth wonder of the world.  We are not sure about that claim (though who are we to argue with Albert Einstein), but we believe that compound interest is key to long term success in the financial markets.

The power of compound interest is derived through the ability to generate revenue from the deployment of your capital in an investment that is then reinvested.  Compounding requires three things to be successful:

  1. An investment that creates a positive return.  Compounding works on investments that have negative returns as well, but that is a different story on risk and money management.
  2. The reinvestment of the earnings.
  3. Time for the reinvested earnings to generate more revenue.  The more time you reinvest your earnings the more the value of your investment will accelerate.

For example, let's say your father was so happy that you graduated from college that he gave you $10,000.  Since you know about compound interest (having read this article) you invest the $10,000 in a mutual fund that is able to return 10% in the first year.  At the end of the year you would have earned $1,000 ($10,000*10%), and the value of your investment would now be $11,000.  Now you invest the $11,000 for the second year in the same investment at the same 10%.  At the end of year two you would have earned $1,100, $100 more than the first year.  This additional $100 is due to compounding.  The increase in the amount made each year continues until you close out of your investment.

Now let's say that another father was so happy that his twin children, T.J. and C.J., graduated from college that he gave each of them $20,000.  (Some children are more fortunate than others.)  T.J., the brother, had not learned about compounding from this site, so he spent $10,000 and kept the remaining $10,000 in his checking account.  He did not want his father to claim he wasted all his money.  Now C.J., the sister, had learned about compounding from this site and she invested her $20,000 in a fund that earned 10% compounded annually.  After five years she had $32,210.  That year the twins talked about investing and she suggested that her brother learn about compounding.  He followed her advice and visited Trading Online Markets to learn the power of compounding.  T.J. then invested his $10,000 he had in his checking account in a fund that earned 10% compounded annually.

Ten years after the twins had received their $20,000 they got together to compare their investments.  C.J. had $51,875 and her brother had $16,105.  Getting together again twenty years after they had received their money they again compared their results.  C.J. had $134,500 and T.J. had $41,772.  Thirty years after receiving their money T.J. had $108,347.  He was hoping he might be getting close to what his sister had.  Well when they got together to compare results he found out he how powerful compounding really is for she had $348,988.

Hopefully, you now appreciate the power of compounding.  In summary:

  • Invest early, since you generate the benefits of compounding and it is very hard, if not impossible to catch up.
  • Reinvest your income to generate more income.  Time works in your favor.
  • Leave your principle in place so you can continue to generate income to compound.
 

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