Why The Younger Generation Should Invest In The Power Of CompoundingSubmitted by Blue Mountain Investment Management LLC on August 13th, 2020
The Logical Sense
We are all familiar with this old saying that “patience is virtue” and that good things come to those who wait. Well, this phrase is best suited for the concepts of compound interest. Albert Einstein said that the principles of compounding can be described as the “Eighth Wonder” of the world due to its compelling forces of investing and financing.
First off, what exactly is a compound interest and how is it calculated? For starters, it is interest calculated on the beginning principal which also accumulates all of the previous period interest. In a simpler term, it is “interest on interest” that grows each year. Thus, being calculated by multiplying the beginning principal balance by one plus the annual interest rate raised to the number of compounding periods minus one. But bear in mind that this is an important part in securing a fruitful life.
(Beg. Principal x 1 + Annual Interest Rate ^ # of Com. Periods -1)
Why Should I Listen?
It can be difficult to persuade the younger generations the time value of money due to various reasons. It is easier to spend money than to save money. Why? Is it because our minds want us to live in the moment or does it tell us to have self-control over our spending habits? The reasons are indefinite--only the person themselves can decide what is the best choice. The best explanation is understanding the opportunity cost-- the value of gaining/receiving something while potentially losing out on alternatives. An example that most young adults are familiar with is by deciding to go to college to improve our lives, the potential loss is not gaining full-time positions and making more money. By choosing one side, the other choice is what we lose out on. Compound interest works in the same way, receive money now or let the time value of money grow.
Factors Involving Compound Interest Returns
Understanding influences that determine your investment with compound interests can be simplified in three components:
1. Interest Rate Returned On Investment
2. The Length Of Time That Money Is Left To Compound
3. Compounding Frequency (Tax Rate)
First, the interest rate returned on investment is simply stating that if a person has a higher interest rate, then the compounding will be stronger. Whereas, if a person has a lower interest rate, it will have a weaker compounding period.
Second, the time left to grow-- the longer money builds and with no interruptions, the more it compounds and bigger return rates.
And finally, compounding frequency or in other words, the number of times in which the accumulated interest is paid out (per year). It makes sense that a person who doesn’t pay taxes will receive far more money, however, in most cases this is not idealistic because we all pay taxes in different ways. It is highly suggested to pay at the end of each compounding period rather than at the end of each year.
Although it may sound appealing to have higher interest rates, it could also be a potential risk if the investor is not careful. The general rule of thumb is that a person would want to avoid the possibility of losing more than gaining, especially if that person’s budget is not capable of exceeding higher return rates.
This type of investment could work for everyone. It is highly recommended to start at a younger age so that the time value of money can accumulate for more years. The struggle of maintaining your compound interest can be painful, but wealth cannot be obtained if patience is not implemented.