🌰In a nutshell: Compounding is the process for an asset to generate earnings, which are then either reinvested or remain invested to generate their own earnings. Start planning your investment early as compounding can significantly increase returns, especially with a long-term investment plan.
To plan your investment, you need to set your goals and plan accordingly. This is for the obvious reason that your goal will dictate your plan. For instance, if you are retired, you might want a plan that is less risky and more liquid friendly. But if you are young and looking to build financial security, things would be different.
In the case of building a long term financial plan, it is important to do it early.
Why? Because time is quite literally money thanks to the concept of compounding.
Compounding is where interest is paid on both the initial capital and any interest re-invested during the time frame. As the interest remains invested with your capital, the interest rate applies to the total sum, resulting in greater earnings the following year. As such, compounding is the engine behind generating significant gain, especially with a long-term plan.
Let’s flesh out this concept by looking into a hypothetical scenario: Mr. Buck vs. Mr. Dog and their investment plans.
Mr. Buck and Mr. Dog are friends. Mr. Buck started was 20 and invested $10,000 which returned 5.5% annually. By the time Mr. Buck reaches 50, his investment would grow close to $50,000 ($10,000 x [1.055^30] = $49839.51)
Mr. Dog, however, didn’t start to invest until he reached his 35. At that time, he also invested $10,000 with the same annual interest rate of 5.5%. By the time Mr. Dog reaches 50, his investment would grow only to $22,325 ($10,000 x [1.055^15] = $22324.76)
When they both reached 50, Mr. Buck’s investment generated $27514.75 ($49839.51-$22324.76) more than Mr. Dog’s. In other words, Mr. Buck generated earnings that are more than twice that of Mr. Dog. That is crazy.
Let’s see the result in a graph so that we can marvel at the power of compounding interest with more ease.
Now, that is significant! This is precisely why the old maxim of “time is money” is quite literally true when it comes to financial investment.
Something you need to remember is this. To experience the wonderful effect of compounding interest to the maximum, you would first need to manage your risk to keep your capital relatively unharmed. When your capital is critically hit, it can really delay returns as it shrinks the ability to generate earnings. Therefore, risk management should take a high priority to stay on track with your financial investment goal.
When you add the concept of compounding and risk management, then it is really easy to understand why building a stable portfolio is important. You need to build a stable portfolio to survive for the long-term and eventually thrive with potentially great returns that are very likely to be more significant than earnings from short-term plans.
You need to build a stable portfolio to survive for the long-term and eventually thrive with potentially great returns that are very likely to be more significant than earnings from short-term plans.
That brings us up nicely to the next topic: risk management.
Let’s talk about understanding the importance of risk. #gotta_manage_risk
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