Compounding, as the name implies, means stacking or combining parts to make up a whole. In finance, compounding can be defined as a process where an invested capital’s profits are reinvested along with the capital continuously, thus generating higher profits. Warren Buffet— the world’s most renowned investor— says that compounding plays a significant role in building wealth and advises investors always to compound their interests to generate larger interests.
As an investor, it is essential to know the critical role that compounding plays in gaining profits and building portfolios. By reading this article, you will learn not only what the power of compounding is but also how it works, the duration to invest to earn maximum compound benefits, the pros and cons, and how to apply the knowledge of compounding interest to crypto.
What is the Power of Compounding?
Compounding simply means reinvesting an asset’s earnings— either from capital gains or interest— to generate additional profits over the period in which its invested. The growth happens because the investment generates interest from initial capital and accumulated profits for the entire investment duration and is calculated using exponential functions. It is worth noting that compounding can also occur in debts, where the amount owed may grow even if payments are made.
Compounding is vital in finance, as it is the driving force of many investing strategies. Many corporations offer dividend reinvestment plans (DRIPs), which allow investors to purchase additional shares using cash dividends. By reinvesting, the increased number of shares means that the interest will keep rising over time.
Furthermore, investing in dividend growth stocks and reinvesting the dividends themselves adds another layer to compounding— called double compounding. Double compounding is beneficial because interest is earned on reinvested dividends and dividend growth stocks.
How Does The Power Of Compounding Work?
To illustrate how confounding the principle of compounding is, imagine this: if someone told you to solve 7+7+7+7+7+7 and 7x7x7x7x7x7 without a calculator, which do you think you’d quickly answer? Many would choose the first one, which is pretty straightforward and has 42 as its answer. The second one, which compounds (multiplies), is 117,649. This result is mind-boggling and utterly depicts the greatness of compounding because your investment doesn’t just grow linearly but multiplies exponentially over time.
Compounding is reinvesting earned interest into the principal (initial investment) to generate additional earnings that are also reinvested continuously. It’s a continuous, virtually unending cycle where you gain interest on top of interest. The aim is to create exponential growth, as the investment will generate earnings from the initial principal and all previously accumulated earnings.
The principle of compounding is that you invest a certain amount, say $1,000, and then it accrues interest. It doesn’t stop there; the interest it accrues over time adds to the initial investment of $1,000 and adds more interest to it. As you may know, compounding is not a game of skill but patience and consistency. The snowball effect is another concept that perfectly illustrates the power of compounding.
When a small snowball starts rolling down the slopes of a mountain, it gathers more snow on its path. The further it moves down the hill, the larger the snowball becomes, and what was initially so small now becomes so large and gains even more rapid momentum. The same is true of the power of compounding— stacking interests until you get maximum gains on your investment.
For How Long Should You Invest To Earn Maximum Compounding Benefits?
For your investment to accrue maximum gains, you need time to let it grow and expand. Warren Buffett is an example of someone who used the secret of time to his advantage. Warren Buffett started investing at 10—very early compared to the average person. Not only did he begin early, but he also kept at it for over 80 years, and now he’s worth about $100 billion. It is worth noting that 99% of Buffett’s wealth came after age 55. You may wonder why, but consider this:
If Warren Buffett compounded his investments from age 10 till about 50 and decided to stop investing and start enjoying his gains, he would have only a few hundred or mere tens of millions—a tiny fraction compared to the $100 billion he’s worth now. This shows that the longer you allow your investment to compound, the higher your returns will eventually be.
Keep in mind that consistency is vital to achieving your compounding goal. For example, if you tell yourself you’re going to invest $1,000 monthly into stocks and reinvest the dividends, don’t stop until you’ve achieved the goal/limit you’ve set already. Also, bear in mind that the power of compounding is realized in later years. Leaving your investment to mature for a long time and produce many fruits is far more beneficial than eating the proverbial “seeds.”
The Pros of Compounding
The Snowball Effect
As explained earlier, this is the capacity of your investment to start small and later grow into something significant. You don’t need to have a million dollars to start investing. You can start with whatever capital you have, remain consistent, and watch your investments grow.
Compounding is a form of passive income that can help you even while you don’t focus so much on it. As you go about your regular work, you can have the satisfaction that your money is working for you to bring in more money.
The Cons of Compounding
The concept of compounding requires years upon years to achieve its fullest potential. The example of Warren Buffett we considered is worth noting in this aspect. Apart from the fact that you need a long time, the most gains are acquired toward the latter part of the compounding period. So if you want to enjoy the power of compounding, you need to be patient and delay gratification.
You need to be consistent when investing. You must be consistent even if you’re willing to wait and spend years compounding. Consistency is key because investing on a hit-and-miss basis will not yield as much profit as it usually would if you stayed consistent, so set a schedule and stick with it. You may save a specific amount weekly or monthly, whichever works best for you, but just make sure you stick with it over time.
Compound interest on borrowed funds or debts can quickly spiral out of control and prove very dangerous. It’s important to understand the very nature of your debt and all its intricacies so that you don’t get weighed down by the financial burden.
Applying the Power of Compound Interest to Crypto
The power of compounding is commonly applied in decentralized finance (DeFi). By reinvesting claimed rewards after staking tokens, they can make more profits because the amount of staked coins will increase, and so will their reward. For example, if you bet 1000 Doge coins and you’re supposed to get 5% APY, the initial reward you’ll get is 50 coins. If you then reinvest these 50 coins with the original 1000 coins, your stake is now 1,050, and your next reward will be 52.5 coins. If you add that 52.5 coins to your original stake of 1,050 coins, you’ll now have 1,102.5 coins which you can keep reinvesting and continue earning.
The principle of compounding is beneficial in the crypto world if you’re patient and consistent enough to reap its rewards. Due to crypto volatility, it is advised to take profits every once in a while, so you don’t lose out entirely if it crashes. Asides from that, you can apply the compounding principle as you wish and profit massively from it.
Compounding means stacking up profits to yield more profits. While it may seem simple, it is more powerful than most people think. You can earn maximum profits on any investments when you know enough about compounding to utilize its benefits properly. As such, it is important to have basic compounding knowledge, conduct proper research and consult your financial adviser before embarking on any investment journey.
Founder & CEO of Vestinda.
Compacting years of investment portfolio building into just a few minutes.