Your money making money for you.
Earnings on Earnings
As it relates to the power of compounding, and the calculation of interest on any investment, there are two basic choices: simple and compound. Simple interest, quite simply put, is you yielding a “set” percentage of your invested principal year after year. Simple interest is not commonly used.
The Compound interest formula is the process by which your investment earnings, say, dividends for example, are reinvested to generate supplementary earnings over time.
Simply put, the power compounding allows you as an investor to earn interest on top of interest, on top of interest…you catch my flow.
It is the single most important reason many investors today are so successful and can be the reason why you, yes you, can be successful at investing too.
Pop any numbers into a compound interest calculator and the results are eye-opening.
The initial impact of compounding may seem trivial, but the balloon effect it produces allows your wealth to grow without much effort – so long as the continued earnings generated by the underlying investment stay steady from period to period.
The Power of Compounding
What does this mean for you? All you have to do to take advantage of the full benefit of compounding is: reinvest all your earnings and sprinkle in some time – a lot of time.
Warren Buffett is quoted as saying the power of “compounding can transform investment earnings into an even more powerful income-generating tool”.
To demonstrate the power of compounding, let’s say you invest $10,000 at 9% simple interest. At the end of year one, using the compound interest formula, $900 is added to your account bringing your total balance to $10,900.
And this is where I begin to get super excited as it marks the beginning of a fun ride. In the second year, your 9% interest is calculated on the entire new balance of $10,900 and not just your initial outlay of $10,000.
This produces an interest payment of $981 for the second year, which is then tacked on to the principal when calculating your interest for the third year.
You will be pleasantly surprised to learn that at 9% simple interest, your $10,000 investment would be worth $37,000 after 30 years. Using compound interest formula however, the value of your investment account would grow exponentially to more than $132,000.
If you are looking for a free compound interest calculator, look no further than investor.gov.
The site is operated by the Securities and Exchange Commission (SEC). If you know anything about the SEC, those guys are thorough. Their free online compound interest calculator is fool proof. It allows you to vary your calculations, including additional units added unto your initial outlay or principal. This way, you get an even more realistic view of your potential earnings over time.
The Rule of 72 as it relates to the power of compounding
This so-called rule calculates the approximate time over which an investment will double at a given rate of return. The rule says that to find the number of years required to double your money control at a given interest rate, you just divide the interest rate into 72.
Let’s say our rate of return is 8%, the rule of 72 is given by (72/8) to arrive at the approximate time it will take for your initial investment to double, in this case, 9 years.
Keep in mind that the rule of 72 is only useful for annual compounding.
Also note that the rule stays remarkably accurate, as long as the interest rate is less than roughly twenty percent. At higher rates, the error starts to become too significant to ignore.
The power of compounding can work a great deal to your benefit as an investor. This is true when it comes to watching your investment grow exponentially, and creating wealth for you.
The exponential growth experienced by your compound interest retirement portfolio is also a mitigating factor against potential wealth-eroding factors. Eroding factors such as, an economic downturn, inflation or rising costs of living.
Contemporary Investment Vehicles
An example of such investment vehicle I have personally tried to leverage the power of compounding, and remain very happy is mentioned below:
Opening an account with Fundrise is relatively easy to do online.
Fundrise and other similar real estate crowdfunding platforms truly let you tap into the power of compounding interest.
With a state of the art investment dashboard and regular updates delivered straight to your inbox, you feel like you have more money control. You can manage your investment portfolio and can stay abreast of how your portfolio of assets is performing.
With Fundrise, you can invest in Real Estate without physically buying any particular real estate venture or physical asset.
When you log into your Fundrise portal, you get to see all the real estate deals in which your money is invested. You are essentially a 100% passive landlord, reaping the benefits of real estate investing, but passing on the hassle of dealing with tenants, costs of repairs, etc.
Fundrise’ returns thus far have been nothing short of amazing. The company reports average returns between 8.76 and 12.42 percent over the last five years.
If as an investor, you choose to take advantage of the dividend reinvestment plan offered by Fundrise, you are potentially unlocking the full power of compounding by letting your money grow, undisturbed, for a good number of years.
You may be pleasantly surprised to see how your investment multiplies, especially if the company is able to sustain the amazing returns it has boasted thus far. Another contemporary investment vehicle, very similar to Fundrise is RichUncles.
Conventional Investment Vehicles
Mutual funds offer investors one of the most common and easiest ways to enjoy Einstein benefits of compounding interests.
You should make the choice to reinvest any dividends obtained from your mutual fund as this increases your shareholdings in the fund.
As more and more compounding interest continues to accumulate over time, the cycle of purchasing even more shares in the mutual funds continues – exponentially increasing the total value of your investment.
Take for example a mutual fund investment set up with an initial contribution of $12,000 and an annual addition of $12,000.
With average annual returns of 8% over a period of 30 years, the future value of the mutual fund is $1,480,152.
The compound interest quote is the difference between the contributed cash to the investment and the actual future value of $1,480,152.
In our example here, by contributing $372,000 over 30 years, the compound interest quote is $1,108,152 which is pretty astounding.