What is Compounding? Compounding is the process in which an asset’s earnings, from either capital gains or interest, are reinvested to generate additional earnings over time. To read this article in Spanish, download the translated version now. Compounding: My Favorite Term
Understanding Compounding
Compounding refers to the increasing value of an asset due to the interest earned on both a principal and accumulated interest.
- This phenomenon, which is a direct realization of the time value of money (TMV) concept, is also known as compound interest.
Special Considerations
Compound Interest
- The formula for the future value (FV) of a current asset relies on the concept of compound interest. It takes into account the present value of the asset, the annual interest rate, the frequency of compounding, and the total number of years.
Difference between simple interest and compound interest
Simple interest pays interest only on the amount of principal invested or deposited.
Increased Compounding Periods
The effects of compounding strengthen as the frequency increases. The more compounding periods throughout a year, the higher the future value of the investment.
- Continuous compounding is known as continuous compounding and can be calculated using the formula: FV = $1,000,000 × 2.7183 (0.2 x 1) = FV.0000000000000001
Which type of average is best suited to compounding?
When computing the average returns of an investment or savings account that has compounding, it is best to use the geometric average, also known as the time-weighted average return or the compound annual growth rate (CAGR).
Example of Compounding
Many corporations offer dividend reinvestment plans (DRIPs) that allow investors to reinvest their cash dividends to purchase additional shares of stock.
- Reinvesting in more of these dividend-paying shares compounds investor returns because the increased number of shares will consistently increase future income from dividend payouts.
The Rule of 72 with compound interest
The heuristic used to estimate how long an investment or savings will double in value if there is compound interest (or compounding returns)
- 72 divided by the interest rate
- Assuming a 5% interest rate, it would take around 14 years and 5 months to double.
