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Why Compounding?

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  • Why Compounding?

    All too often I see it referenced that compounding is another wonder of the world. This is typically noted when talking about investing, but investing isn't really "interest" in the traditional sense. It just seems odd to me. So why is it thrown out so often? I understand that the dollars from your younger years are more valuable, and will have the longest exposure to the market. It still doesn't seem like compounding is the right word. I am still naive, so someone educate me. Thanks for your time.

  • #2
    I have had the same question myself, because the common use of the word is as an adjective, as in "compound interest". Compounding, however, refers to the reinvestment of earnings to deliver more earnings on an ever-growing pool of principle. in the context of investing, compounding refers to dividend and capital gains reinvestment, which adds to the principle, creating a larger pool of principle to throw off dividends and so forth.

    I hope this helps.
    Working to protect good doctors from bad advisors. Fox & Co CPAs, Fox & Co Wealth Mgmt. 270-247-6087

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    • #3
      compounding to me means things get added to the previous or accumulated pool.

      so every year if you make 4%, its not just a linear growth. that 4% gets incorporated to the previous year thus making it an exponential growth.

      so yes, early dollars are worth way more as they have the chance for small percentage changes to accumulate huge shifts.

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      • #4
        Simple 5% growth, such as non-capitalizing interest on a loan: P x (1+rt)

        • 1 year: 1.05

        • 2 years: 1.10

        • 3 years: 1.15

        • 10 years: 1.50

        • 20 years: 2.00


        Compound 5% growth, such as earning 5% a year on a mutual fund and re-investing it: P x (1+r)^t

        • 1 year: 1.05

        • 2 years: 1.1025

        • 3 years: 1.158

        • 10 years: 1.623

        • 20 years: 2.653

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