Compounding: peculiarities of the concept in investment activities
The term “compounding” is used in various fields. In the financial sector, it refers to the ability of an asset to generate income that can be reinvested to generate additional sources of money. Simply put, compounding refers to generating new funds on the basis of previous income; in some cases, the term is also used to refer to compound interest.
The essence of the concept is better considered with an example. For example: investing 50 thousand dollars in the stocks of a company. During the year the rate of securities rose by 15% and, accordingly, the investment grew to 57.5 thousand dollars. In this case, the profitability of the initial investment is considered quite high, so the best solution is to keep the shares for another year. The second year also brought a gain of 15%, and if similar dynamics will continue in the future, one can count on a large income. In this case, it should be taken into account that the amount will grow not only from the initial figure of investment but also from the annual interest. For example, an investment of $100,000, assuming a 10% annual interest after 20 years, would be $672,750 without any additional funds.
Closely related to the concept of compounding is another one – discounting. It is a procedure for determining the present value of funds based on their future value. Discounting is used when it is necessary to find out how much profit an investor will get based on today’s valuation. In this case, everything depends on the period of investment for a certain income – the longer it is, the lower the value of the asset at the moment.
Investing funds, you should understand that the process of depreciation of money cannot be stopped, it occurs regularly and constantly. To minimize losses, financiers recommend periodically making investments of capital, pre-determining the minimum amount for this. To do this, the investor analyzes how much income he can get in a year, two, or 10 years, assesses his current financial capabilities and then decides on the amount of investment.
With compounding, the investor uses the compound interest rule, which allows the investor to determine income after a certain period of time. In this case, the evaluation is made from the amount at the current moment and to a future figure. The interest rate of return and the term of the investment are also taken into consideration.
Thus, the investor should understand whether it is worth investing money in this or that project, and how high the income will be. By evaluating your current capabilities, and predicting an increase in the amount in the future, you can avoid losses and accelerate the increase in equity.
