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Smart investing is a bit like personal development or going to the gym. If you want your money to reach its full potential, it should always be working on itself. Amateurs are satisfied with initial gains. Professionals use them as fuel for more.
That’s basically the idea behind compound investing. To maximize growth, all new earnings should be reinvested, as quickly and as often as possible. This core concept often makes one investment far superior to another, even when the two looks deceptively similar in terms of rates of return or duration.
The post below will help you spot compound investing opportunities and avoid letting your money sit idle.
A simple investment return pays out a steady, predictable payment based on the return rate that’s being applied to the initial investment, or principal. Importantly though, the returned payments are not reinvested, so the return doesn’t compound over time.
Before we unpack the magic of compound investing, let’s start with a baseline of investments that carry simple interest. The standard caveat here applies: this blog advocates for sharia-compliant investing, which does not use interest, but for educational purposes we’ll explore how simple investment return payments work.
Investments that work based on simple interest without compounding include all sorts, from certain government bonds to certificates of deposit. Some loans also work based on simple interest, with the borrower paying a steady rate on the principal until the debt is repaid.
Let’s take the example of a certificate of deposit (CD) with the following characteristics:
● Principal amount invested: $10,000
● Annual interest rate: 4 percent
● Investment term: 3 years
Each year, the CD will pay out four percent interest. In the above example, that means $400. Thus, after three years, you’ve earned $1,200. Your $10,000 principal is now $11,200. Not bad, but as you will soon see, compounding could give you more.
To put this in basic mathematical terms, you can express it as:
● Simple Interest = P × r × t
○ P= Principal amount; r= annual interest rate; t= time
The answer is it depends. Compound investing will always yield higher returns than simple interest, but how much better depends on how many times, or how frequently,
you can reinvest the money you’ve earned, also known as compounding the interest or earnings. Let’s take the same example from above, except this time, compound the interest earnings one time per year.
● A= P × (1+r/n)n×t
○ A= Total amount; P= Principal amount; r= annual rate of return
○ n= number of times compounded per year; t= time
So, for the example above, we want to compound our principal of $10,000 one-time per year at the given interest rate of 4 percent. Another way to look at this is that we will be taking the interest earnings and reinvesting them three times – once per year – and earning a four percent return on that new money as well.
If we plug our CD example into the compound investing equation, we will end up with total interest after three years of $1,248.64.
Compound investing pops up in all sorts of investment schemes. For example, stocks that pay dividends and allow investors to reinvest the dividends to buy new shares, also known as a Dividend Reinvestment Plan (DRIP).
Mutual funds, index funds, retirement accounts and bonds often work the same way, reinvesting the earnings automatically and thus offering higher returns.
Read more about: What Are The Differences Between Mutual Funds, Index Funds & ETFs?
At first glance, the difference between simple interest and compound investing might seem modest – in our example, the $1200 we earned on simple interest only grew to $1,248.65 after the earnings were compounded.
But that’s just the tip of the iceberg. As compounding becomes more frequent and the duration of the investment stretches out over time, the differences become profound.
To put it differently, with simple interest your money’s growth is linear and steady. With compound investing, the growth becomes exponential, because each period’s growth builds upon the previous one. It grows faster over time, like a snowball.
When it comes to compound investing, you can use the Rule of 72 to know approximately how long it will take for your money to double in value. With the Rule of 72, you can divide 72 by the annual interest rate to know how long it will take for your principal to double.
In mathematical terms that would be:
● Doubling Time = 72/ r
In our CD example, you would divide 72 by 4, the annual rate of return. Since 72 divided by 4 is 18, it means that it would take about 18 years for your initial $10,000 to double and become $20,000.
The takeaway? If you’re not reinvesting your earnings – or compounding them – you’re leaving money on the table.
Disclamer:
This post is for educational purposes only, and the Firm does not directly or indirectly provide these services.
