The basic principle behind compounding is that the interest earned by a loan or deposit also earns interest. For compound interest to be computed, there must be a principal, an interest rate, compounding frequency, and the total number of years the principal will be left to earn interest. The compund interest will be higher if the interest is computed more frequently.
The Difference Between Compound Interest And Simple Interest
With simple interest, the interest computed isn’t added to the principal. The interest doesn’t earn interest. Economics and finance use compound interest more frequently although there are financial products which use simple interest. Thus, investors must prefer compound interest because their wealth grows faster with it than with simple interest.
Common Usages Of Compound Interest In Finance And Economics
In economics, the effective annual rate is more frequently used because it allows for better comparability. In business and finance, the nominal annual rate is often used. For loans, the nominal annual rate can be easily quoted. However, there can be difficulty in comparing the nominal rate of various loans because they can differ in compounding frequency.
The effective annual rate is just the total interest payable in 1 year divided by the principal amount. The nominal annual rate, on the other hand, is the interest rate for 1 period multiplied by the compounding frequency in a year.
What Is The Time Value Of Money?
In essence, the time value of money simply means that it is better to have the money now than have it at a later time. This is because the US$500 you have now isn’t worth the same when you receive the same US$500 at a future time. You won’t be able to buy the same amount of products and services in the future as compared to what you can buy now. Inflation eats up the value of money over time.
However, you can counter the ill effects of inflation by investing your money so that it can earn interest. For this to work, the interest rate must be greater than the inflation rate. Compounding interest can mitigate the effects of inflation to ensure that your $500 today can buy at least the same amount of goods and services in the future.
The Dark Side Of Compound Interest
In most cases, investment companies advertise about average returns. To the untrained individual, he may easily be encouraged to sign up with the particular investment scheme without knowing that the average is nothing compared to the real thing, the compound return.
There are two ways compounding can work against the investor: negative returns and dispersion of returns. Investing in volatile markets can have great rewards but it can also bring about the worst losses as well. It is possible for a positive compound interest in the past can be affected by any present negative return. If the loss is so great, the investment can have a difficult time to break even.
In dispersion of returns, the compound return can drop greatly if the returns are highly volatile. The compound returns become smaller when the dispersion widens. Both the negative returns and dispersion of returns can wreck havoc to an investor’s portfolio. However, there are workarounds available so that even during these trying times, the investor can still take advantage of compounding.
Hurdling The Ill Effects Of Compounding
Compounding can have positive as well as negative effects. For the investor to be successful in it, he must do his homework and be disciplined. He must be able to spot market trends and ensure that he invests on the trend and not against it. Taking advantage of bullish trends can harness the true power of compounding and provide the best possible returns to the investor.
However, it can be tricky in bearish trends. The investor must be able to pick investment schemes wisely. Diversification of the same investment portfolio may not work because the market is on a down trend. It may be best to counter a bearish trend with a hedge using another investment scheme which will give a safer return on investment. Shorting the problematic investment can also be a good strategy.
It’s Time to Just Re-balance Your Portfolio
As a general and proven strategy, it is best to re-balance the investment portfolio from time to time. Top-earning investments can be sold while they are still providing the best returns rather than wait for these investments to decline in value. This will also provide fresh capital to invest on emerging markets. Working proactively to stop any negative effect of compounding can bring about the best invesment positions to an intelligent investor.