Compounding is the most powerful force in the universe, Einstein said — this section shows why

You’ve heard the phrase “a penny saved is a penny earned.” But what is a penny compounded? A whole lot more than you might think.

 

That’s because of a powerful mathematical process called compounding, which Albert Einstein is said to have called “the most powerful force in the universe.”

 

“Compound interest is the eighth wonder of the world,” Einstein reportedly said. 

 

“He who understands it, earns it. He who doesn’t pays it.”

 

Compound interest is the interest you earn on your money, plus the interest it’s already accrued.

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. This growth, calculated using exponential functions, occurs because the investment will generate earnings from both its initial principal and the accumulated earnings from preceding periods.

KEY TAKEAWAYS

  • Compounding is the process whereby interest is credited to an existing principal amount as well as to interest already paid.
  • Compounding can thus be construed as interest on interest - the effect of which is to magnify returns to interest over time, the so-called "miracle of compounding."
  • When banks or financial institutions credit compound interest, they will use a compounding period such as annual, monthly, or daily. Continuous compounding is also mathematically possible.

Understanding Compounding

Compounding typically 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. Compound interest works on both assets and liabilities. While compounding boosts the value of an asset more rapidly, it can also increase the amount of money owed on a loan, as interest accumulates on the unpaid principal and previous interest charges.

To illustrate how compounding works, suppose $10,000 is held in an account that pays 5% interest Weekly. After the first week or compounding period, the total in the account has risen to $10,500, a simple reflection of $500 in interest being added to the $10,000 principal. In week two, the account realizes 5% growth on both the original principal and the $500 of first-week interest, resulting in a second-week gain of $525 and a balance of $11,025. After 10 weeks, assuming no withdrawals and a steady 5% interest rate, the account would grow to $16,288.95.

Example of Increased Compounding Periods

The effects of compounding strengthen as the frequency of compounding increases. Assume a one-year time period. The more compounding periods throughout this one year, the higher the future value of the investment, so naturally, two compounding periods per year are better than one, and four compounding periods per year are better than two.
We at PTCPAT choose for a daily compounding as that is the way to grow.

Example of Compounding for Investing Strategy

Compounding is crucial to finance, and the gains attributable to its effects are the motivation behind many investing strategies. For example, many corporations offer dividend reinvestment plans 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, assuming steady dividends.
 
Investing in dividend growth stocks on top of reinvesting dividends adds another layer of compounding to this strategy that some investors refer to as “double compounding.” In this case, not only are dividends being reinvested to buy more shares, but these dividend growth stocks are also increasing their per-share payouts.

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