Let’s say you’re creating an investment portfolio, and have diversified investments. The earnings on your investments each year add to your wealth. You can take out these earnings as extra funds to use as you please. It is your money, after all.
However, if you put these earnings to work, you could increase your wealth over a few decades.
Compounding Your Earnings
The formula for calculating your earnings through compound interest is:
A = P (1 + r/n)^ (nt)
A = the future value of the investment
P = the principal, or the original amount invested
r = the annual interest rate in decimals
n = compounding frequency (the number of times that interest compounds per year)
t = the term or the number of years the money is invested
Albert Einstein is said to have described this formula as â€œthe greatest mathematical discovery of all timeâ€�. This illustrates the power of compounding.
What Compounding Can Do For You
Compounding is when your earnings are reinvested and the interest becomes principal. Suppose you invested $1000 at 6% and it earns you $60. You then put this back in your investment and now the total principal is $1060. The next interest calculation will be on this amount, increasing your earnings ($63.60). You then add the new earnings to the principal (1123.60) and the next time you will earn even more.
Choose quarterly compounding rather than annual compounding. Now n will be 4 instead of 1. The interest applied each quarter would be less but increased frequency of interest will realize higher returns.
The Time to Grow
The term of the investment, the t in the formula, also plays a great role in influencing what you earn. Imagine two people invest the same amount, at the same rate of interest, but start at different times. There could be a big difference between the early investor earnings compared to the one who started later. Even a 5 year delay could make a huge difference. The longer the time you give your money to grow, the better the returns.
Now consider a portfolio with investments of various types. Shares in different companies, investments in debt securities, and savings accounts with compound interest. Combined together, the returns could be huge, even allowing for intermittent losses.
When you are creating an investment portfolio for your retirement, start young, preferably in your twenties. Invest in a mix of equity types. Create a few income generating investments for the future. For other investments, choose to reinvest the earnings. You will enjoy the power of compounding earning. Start early and realize the power of time.