Compounding is the process of accumulating interest in an investment over time to earn more interest. In this compounding process, interest paid each year remains in the bank account, or in the brokerage account, to earn more interest.
Compound interest is interest calculated not only on the initial principal, but also on the accumulated interest of prior periods. Therefore, compound interest is interest earned on both the initial principal and the interest reinvested from prior periods. So, compounding isthe accumulation of a growth rate over a period of time.
Compounding is the opposite to discounting.
How does compounding work?
If you have USD$100 and decide to place it into a bank account paying 5% interest annually, at the end of the year you will have USD$105. If this was saved for another year, then the future value would be USD$110.25 (USD$105 plus another 5% interest).
If you are investing USD$100 at an interest rate of 5% per year for 10 years, then the future value of the USD$100 will be 1.05^10 multiplied by USD$100 which is USD$163.
If USD$1,000 received today can be saved at 10% interest annually, then it will grow to USD$1,100 in one year’s time.
The ‘Rule of 70’ of compounding
In the economy, if incomes grow at 1% per year, it will take about 70 years for incomes to double (70/1). However, if incomes grow at 3% per year, it will take about 70/3, or 23 years, for incomes to double.
The secrets of compounding
It is worth remembering that even growth rates that seem small when written in percentage terms seem large after they are compounded for many years. Given enough time, even modest investment returns can generate real wealth. This secret is the extraordinary power of compounding.
Compounding is the reason it is so important to begin investing when you are young!
Two real life stories about compounding
The first story is about Warren Buffet, and the second story is about Benjamin Franklin.
Story 1: In fact, this single concept is the cornerstone of billionaire Warren Buffett’s vast fortune. He recognized the idea when he was ten years old and it guided his decisions ever since. Here is a quote from a recent Warren Buffett biography: ‘The way that numbers exploded as they grew at a constant rate over time was how a small sum could turn into a fortune. Buffet could picture the numbers compounding as vividly as the way a snowball grew when he rolled it across the lawn. Warren began to think about time in a different way. Compounding married the present to the future. If a dollar today was going to be worth ten some years from now, then in his mind the two were the same.’
Story 2: For a brilliant example of compounding in real life turn again to Benjamin Franklin. When he died in 1790, Franklin left the equivalent of USD$4,400 to each of two cities, Boston and Philadelphia. But his gift came with strings attached. The money had to be loaned out to young married couples at 5% interest. What is more, the cities could not access the funds until 1890 – and they could not have full access until 1990. Two hundred years later, Franklin’s USD$8,800 bequest had grown to more than USD$6,500,000 between the two cities! True story.
Small growth compounded over long time brings big results
Growth rates compounded over many years can lead to very spectacular results. That is probably why Albert Einstein once called compounding ‘the greatest mathematical discovery of all time’.
