Compounding is a method of growing an asset by ploughing back returns realised from capital gains, interest or dividend in order to generate more returns over time.
How would you pick: N10 million today or N1 that doubles every day for the next 30 days?
This question reveals more than the beauty of mathematics and how urgent you might need cash; it shows a smart way of growing your wealth by leveraging compounding.
In order words, compounding allows you to grow your wealth exponentially through gains realised from the initial principal and subsequent earnings actualized from each period of investing.
Here is how compounding works:
Suppose you keep N10,000 in a savings account that pays 5% interest annually, after the first year you receive N500 as interest and your balance grows to N10,500.
If in the following year the money is left untouched, the balance would grow by another 5% on both the initial N10,000 paid and the interest of N500 received at the end of the first year.
As a result, the account balance would increase to N11,025 as the principal gains N500 and the interest gains N50.
Should the process be allowed to continue uninterrupted, after 15 years, the account would grow to N20,789.28.
You might wonder why in the example above it takes 15 years to double the principal. The true strength of compounding lies in the longevity of the period of investment which makes it very useful for saving towards retirement and long-term goals.
Another factor that is important is the rate of interest which determines how fast the principal grows. Like you would find out shortly, a penny today can become so much more when compounding is applied to high yielding investment assets. In cases where return i.e interest is high, then wealth can be grown exponentially even over a shorter span.
Apart from savings towards retirement, child’s education or even the acquisition of an asset, you can apply the principle of compounding to your stock investment by reinvesting your dividend.
N10 million today or N1 that doubles every day for the next 30 days?
If you get N1 doubling every day for 30 days, you would earn N1.07 billion at the end of the last period!
Even though you started with very little capital, at an attractive rate you could realise multiple folds through the consistent saving of principal and interest.
