The Basic Components Of Compounding

There are three main components that make the compounding process complete. They include your reinvestment, time, and the interest rates.

Do you know that if you invested one kobo and doubled it every day, you would have will have over 5.4 million Naira in just 30 days? This is a very basic example of what compounding is all about and it is an investment principle that can make all the difference between investors. Also known as compound interest, the general idea of compounding is to generate earnings from past earnings. By our little analogy, you can tell that the result of compounding is usually exponential growth. On the flip side, the result of not compounding is as simple as investing only your first one kobo and constantly spending the rest – you end up exactly where you started.

There are three main parts to every compounding process and they are:

1. Reinvested Earnings/Interest received/Profits/Dividends and

2. Time

3. Interest rates

REINVESTMENT

The kobo doubling analogy seems extreme, especially because unless it’s a Ponzi scheme straight out of hell, nobody is going to give you 100% on your investment every day. So let’s use a simple analogy. Let’s say Kojo invests N10,000 today at a 20% interest rate/ annum.

By the end of the first year, he have N12,000 (N10,000 x 1.20). Instead of withdrawing the extra N2,000 gained, if he invests it for another year, at the same rate, he would have made 14,400 by the end of the second year (N12,000 x 1.20). If he continues like this, in twenty years he would have made N383,376, just with an initial investment of N10,000.

If, however, Kojo decided to spend his gains every time they come on pepper soup, by the end of ten years, Kojo would have the same N10,000 to his name. With inflation, both figures will be reduced and this means that without compounding, even the initial investment will reduce. This is the role reinvestment plays in the compounding process.

TIME

There is a reason people are advised to start early and that reason is time. Time is a key component of the compounding process because it is what gives the investment room to grow exponentially.

For example, holding all assumptions static, if Kojo withdrew his investment after ten years because he was planning his birthday party, he would have made N61,917 compared to the N383,376 he could have made in 20 years; the N2,373,763 he could have made in 30 years and the N91,004,382 he could make in 50 years.

From just an investment of N10,000!!! The difference is lies in starting early, and also in investing for a long term.

INTEREST/DIVIDEND RATES

Most sources will show you that reinvestment and time are the two components of the compounding magic. But it is because this is expected: a higher interest yield will always mean increased odds.

If the interest rate Kojo was offered was 50% instead of 20, in twenty years instead of making N383,376, he would have made an impeccable N33,252,567. As such, the quality and performance of the investment chosen plays a big role in the long run.

The other factor, of course, is the risk element. Significantly interest rates always mean higher risks and this is where your risk threshold comes to play. It is where you find your balance.

When crafting your investment strategy, it is important that you bear this simple process in mind because its exponential effect can make you uber wealthy but it can also leave you with a barrage of regrets. Luckily, two out of the three components are completely within your power. You can determine your outcome.

Written by Lawretta Egba.