The Power of Compounding (Part 2)
Now that we know what investing is, we need to address how investing works. Investing works because of compounding. Compounding is an asset's ability to generate earnings (capital gains and interest) that are reinvested to make more earnings. Confused? Let's try an example:
If you have a $10,000 investment that generates 10% at the end of the year you now have $11,000. If you kept the $1,000 in the investment account, instead of taking it out, that means you reinvested your earnings. If the next year your investment account also generates 10% you will have $12,100 because you started the year off with $11,000 invested instead of the $10,000 baseline. Compounding allows your investments to grow at a larger pace!
Year 1: $1,000 return
Year 2: $1,100 return
That seems like a small increase of $100 now but the longer that you leave your money invested, the higher the compounding, and the greater the amount of money you will have. Your money is able to grow at an exponential rate because your money is leveraged such that your principal (the original amount of money you invested) AND its earnings continuously grow day-in and day-out.
Compounding is where the real magic of investing happens because money can literally grow on itself. The earnings you make from principal investments immediately gets put to work for you.
Fun Fact: Debt works in the same way! Have you ever noticed that you can't seem to get out of debt and that the money you owe has snowballed into something far greater than what you originally purchased? That's because debt also compounds, but in the opposite direction. So, if you have a high interest rate on a credit card and you keep putting off paying off the balance of your credit card, the debt soon can become unmanageable.
This phenomenon is why the poor get poorer and the rich get richer. It's math!
Next up, we will discuss how TIME plays a role in your finances.