THE MAGIC OF COMPOUNDING

The Magic of Compounding

While diversification is referred to as ‘the only the free lunch’ in the investment world, traders often quote the effect of compounding as being the eighth wonder of the world. It’s seemingly magical ability to turn small amounts of money into vast fortunes has been harnesses to great affect by some of the world’s best traders. It is a secret you would be foolish to ignore.

Two different techniques of using money management in markets and showed that fractional bets can be an effective way of growing wealth. Investing a percentage of your capital instead of a fixed sum allows the magic of compounding to take place and enables a more optimal bet size to be placed. The best way to see this is to look at an example:

Let’s say that Trader A saves $25,000 of his salary per year while Trader B starts off with just $1 and doubles it each year. Under this scenario, it would take Trader A 40 years investment half of his salary to become a millionaire, meanwhile Trader B has invested just $1 and has reached a million in just 20 years.

Doubling your money every year like this may not be realistic, however the principle of compounding remains the same—the sooner you start, the sooner you benefit.

As another example, let’s say Trader B starts investing at age 24 and puts $2,000 a year into the market for the next six years, in a portfolio that returns 12% Meanwhile Trader A waits until 30 before also investing $2,000 per year and invests the same amount each year until the age of 65.

By retirement then, Trader A and Trader B both millionaires, however, Trader B has invested just $12,000, over six years, while Trader A has invested $72,000 over 36 years. As you see, the effects of compounding increases with time and the sooner you can put your money to work the better.

          Formula for compounding:

          FV= P (1 + i) n

          Where:

          FV=future value amount including the principal

          P = principal amount

          i = rate of interest per year

          n = number of years invested

In order to fully benefit from compounding you therefore need to invest at the highest level of interest for the longest period of time. A portfolio that returns just 3% a year turns a sum of $10,000 into just $18,000 after 20 years. While a portfolio that returns 20% per year turns the same amount into nearly $400,000.

It therefore makes sense to aim for high-yielding investments if you can—especially while young—in the hope that they balance out over time.

This Article is taken from How to Beat Wall Street

Written by Arshad. A

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