Compounding - Explained
What is Compounding?
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Table of ContentsWhat is Compounding?How Does Compounding Work?Compounding as the Basis ofFuture ValueCompounding for Investing Strategy
What is Compounding?
Compounding is a term used in different disciplines and fields of study. In the context of investment, compounding is a financial term that describes the ability of an asset or security to generate more earnings when reinvested. Investors make investments to make profits, oftentimes, when earnings are made on an asset or security, investors seek to reinvest the earnings in order to receive more earnings. The earnings that can be made on an asset can either be through interests of capital gains, when the earnings are reinvested and they also yield returns, the compounding effect has taken place. The compounding effect is due to both the principal investment and the earnings yielding returns during a particular time.
How Does Compounding Work?
Linear growth pf an asset is different from compound growth, in linear growth, only the principal yields interest or returns while in compound growth, both the principal and accumulated earnings yield returns. Usually, compounding helps investors grow their money faster than linear growth. When compound interest takes effect, an investor earns interest on both his principal and accumulated earnings. For instance, if an investor holds a sum of $50,000 in an account that yields a 10% interest annually, this means that $5,000 will be paid as interest in a year. Instead of withdrawing the interest earned, the investor can reinvest the $5,000 earning which will also attract an interest of $500. This can be done for a period of time, this pattern is referred to as compounding.
Compounding as the Basis ofFuture Value
Compound interest is a key metric in compounding, this is the interest rate used in compounding. The general formula for calculating compound interest is; FV = PV x [1 + (i / n)](n x t) In the formula above, FV means future value, PV means present value, i means the annual interest rate, n refers to the number of compounding periods per year while t refers to the number of years.
Compounding for Investing Strategy
In finance, compounding is an important strategy that informs investment decisions made by individuals. Individual investors, large or institutional investors, and corporations make reinvestment decisions in order to increase their profits. Rather than collecting their dividends or interest earned, investors reinvest for the assurance of higher returns. Reinvestment is a key strategy for dividend growth and serves as a way of making huge profits in a faster way. In certain cases, investors opt for double compounding which refers to an act of adding another layer of reinvestment to the initial investment and reinvestment.