The Power of Compounding
The Power of Compounding
Age should never be an obstacle on your road to investing. Saving up for rainy days sounds like a viable plan. Yet, to do it accordingly, you will need to get on the right side of investing. When it comes to investing in your future, the earlier you start, the more financially potent you’ll become down the line. By giving your money enough time to grow, you learn the pattern of discipline as well as the importance of financial independence. One of the ways to accomplish your financial goals is through compounding. With this superb financial tool, every pound you invest puts more money in your pocket and saves it for the future. Saved cash earns more interest, and the longer it does, the faster you can compound your earnings. But, let’s not get ahead of ourselves. For the less informed and those looking to invest in a financially safer future, let’s examine what compounding is, how it works, and how it serves your long-term savings plans.
What is Compounding?
By definition, compounding is an asset’s ability to generate earnings over time. These earnings are later reinvested or maintained as an investment that continues generating profits. To put it simply, compounding is the process of generating future earnings based on earlier ones. Financial planning refers to many more aspects of life other than pensions, retirements, and purchasing real estate. Developing a suitable financial strategy that will allow you long-term financial security is a huge plus. Compounding is a method designed to ensure that you have multiple sources of earnings - now as well as in the future. With continuous compounding, every dollar earned begins to earn interest - on itself. Compounding, as a tactic, is not to be mistaken for linear growth, where only the principal earns interest.
How to Calculate Compounding?
Many Australians might turn to compounding as an investment method. Even so, they remain unaware that evaluating compound interest is an important part of the earning process. Therefore, when implementing compounding as a tactic, it is paramount that you start planning as early as possible. This way, you will be aware of your existing balance and will know what exactly you are investing in. The good news is, compound interest can be easily calculated, even for rookie investors.
To calculate it, multiply the principal initial principal by one, plus the annual interest rate increased to the number of compound periods, minus one. Thereafter, the initial loan amount will be subtracted in total from the value.
In formula, here’s what it looks like:
[P(1+i)n ] – P = P[(1+i)n – 1]
Here, P stands for the principal; i is the nominal annual interest rate in %, and n is the period of compounding.
What Types of Investment Can I Compound?
You will always have the choice and freedom to invest in anything you want and consider the most profitable. But, not all assets can compound positively. It takes time, patience, and careful planning to truly succeed in compounding and get settled for your golden year, finance-wise.
At the same time, there are several types of investments that can compound easily, and you can choose the one that suits your future goals the best.
High-Interest Savings Accounts
This is an investment pricier than others. However, high-interest savings accounts earn a better interest rate, which makes the extra investment worth it. Banks can lend out the cash you invest into your savings account. In exchange, the bank will pay your interest for not withdrawing the funds you have. Here, you will earn the interest rate based on your deposit. For thousands of Australians, these investments are considered fast and low-risk.
Money Market Accounts
Basically, money market accounts operate the same as high-interest savings accounts.
The only exception is that you will be able to make ATM withdrawals and write checks. These investments are often paid slightly better than the Savings accounts. One of the cons, however, is that your account will impose a monthly limit of transactions you can do, and some of these might even charge a fee.
To get more out of your stocks, dividend-paying stocks are a suitable solution. Here, you should instruct your brokerage to generate compound interest and reinvest the stocks automatically into buying more shares. Preferred stocks are a good option to consider as well. They are not traded as often as regular stocks. Ultimately, it will all boil down to what works for your investment plans the most. Picking the wrong option will make you unable to receive the desired dividend boost.
Why is Saving and Investing Important at a Young age?
Investments aside, during your youth, your greatest financial asset is having enough time. After you have paid your bills and have set-aside enough to pass the month, it’s a smart idea to begin investing and spend what’s left for partying and hobbies. Not every penny you have has to be spent immediately and on, dare we say, future-irrelevant aspects. At a young age, discipline can be learned the easiest if you first invest, and only then spend the leftover cash for partying and shopping. The risks are more severe when you earn from returns. Losses can happen, of course, but if you use your money wisely, you will have more time and freedom to recover from the financial rut. By losing some you gain some, so take any mishap down the line as a learning curve that will teach you how to gain financial freedom without overspending and overinvesting.
Is There an Ugly Side to Compounding?
Everyone’s compounding goal is to never lose any money. However, dealing with finances and investments always comes at a risk, so take it as part of the process. If you have entered investment waters, treating compounding only as a positive and never as a negative is a wrongful tactic to rely on. Whilst compounding is highly beneficial for your investment plans, it can also end up in you choosing an inadequate investment option.
Therefore, it’s wise to do your homework and understand how compounding helps you earn money but also how it can cause you to lose them. Investing is always a risky process but when conducted rightfully, the downs are largely overshadowed by the ups. Choosing the right investment and managing it closely is of crucial importance in compounding, especially if you are aiming for more gains than losses.
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Disclaimer: Information included in this post is of general nature, it has been prepared without taking into account your specific situation. It is not intended to be and does not constitute financial advice, investment advice, trading advice, or any other advice. You should not make any decision, financial or otherwise, based on any of the information presented here without undertaking independent due diligence and consultation with a professional accountant or financial adviser.