Roll of Compound Interest In Stock Investing

Probably you may not be fully aware of the Power of Compound Interest in stock investing. Albert Einstein described compound interest as the eighth wonder of the world as it seems to possess magical power. It helps you becoming millionaire, comfortable retiring or financially independent. If want to assimilate more about it I suggest you should read ‘The Magic of Compounding . Even if your children master this concept, they will definitely be on their way to riches.

The Basics of Compounding:

Imagine, you might have an option to choose between two. Earning $10,000 a day for 30 days or a penny that doubled in value everyday for 30 days? If you know the math you’ll go for second option. Why? Because second choice can give you an astounding $5 million USD whereas first option earn you merely $ 0.3 million USD

How it works:

This is not a rocket science. It’s like earning interest on interest. If your investing horizon is 10 years period, you’re not allowed to withdraw any component of money within this period. Now, if you’re investing $1000 for an annual return @10%, you’ll get $1100 at the end of 2nd year. At the end of 3rd year, you’ll get $1210 and so on. And finally, at the end of year 10, your total accumulated earnings become $2994 Amazing, isn’t it? Moreover if you want to delve into the details of calculation, you can find dozens of websites that would give the exact formula of deriving the outcome.

Why Compound Interest is termed as 8th Wonder of the World:

The important concept about compounding is that the early you start off, the better it would be. A realistic situation will help you enormously and can make you millionaire to the true financial freedom. Let’s assume you’re 24 years old and start saving $2000 per year for 6 years till the age of 30 in a well managed rated SIP (Systematic Investment Plan) fund.  And say your elder brother Joy, aged 30 years starts investing $2000 annually in the similar fund till the retirement age of 65 years.

Both of you are earning 12% after-tax return and are not allowed to withdraw any component of the money invested. Importantly you’ll need to contribute the same money annually in the savings fund for 6 years only and keep invested till 65 years of age. However, your brother Joy needs to invest $2000 annually till his retirement age of 65 years.

Now it’s your spellbound time to know the very interesting & eye-opener read of your life. Yes, it’ll make you very wealthy. You’ll need to save $2000 just for 6 years (6 x $2000=$12000) and keep waiting till the age of 65 years. But Joy need to keep invested @$2000 annually for 35 years (35 x $2000=$72000) till his retirement age of 65 years.


So, at the time of retirement how much money will you get in your hand? Its eye-catching $ 988,000 and your brother Joy will accumulate $ 928,000 Imagine the power of early start and compounding. Seems like an easy choice, doesn’t it? Just do the calculation for yourself at financial calculator.

But if you go along the path of savings interest rates, you would need to save $25,000 a year for 40 years to reach $1 million. This is somewhat out of reach for many.

Why Is Compound Interest Vital in Stock Investing:

 If your SIP Company’s earning potential is more, you’ll get astounding result. But your investment amount, an early start, the rate of return you earn from investing is very crucial. For best interest rates, the more you invest the money you’ll have later. Let’s say one of your buddies Tom was in the similar situation. But he failed to make a good investment decision and earned 4% compound interest rate. Unfortunately he ended up with only $56,620 whereas you managed to amass a whopping $1,074,968 with 12% after-tax interest rate.

Fundamentally good stocks have that kind of potential to deliver astounding return. Growing CAGR of more than 15% is common for good stocks. In the short run, stocks may be a bit riskier investment, but in the long run the rewards can certainly be outweighing the risks.

The Take Away:

Compound interest can help landing you on a true financial freedom in life when you use it most effectively by starting investing early, invest as much as possible, and try to earn a reasonable rate of return.

Source: http://news.morningstar.com

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