The Power of Compounding
When it comes to building wealth, the concept of compounding cannot be emphasized enough. Even Einstein said that the power of compounding is the most powerful force in the universe!
Simply said, compounding is the effect of interest growing upon interest that is added back into the principle. Think of how loan sharks earn money and you will understand the power of compounding. While most people can understand the advantageous effect of compounding, not that many realise that compounding is a double edged sword and can work against you as well.
For example, the effect of inflation is actually negative compounding. It makes your money shrink in compounding mode instead of growing. We can look look at inflation as the growth in the price of goods. Lets compare the effects of a 7% annual growth rate on $100 investments and a 7% annual inflation rate on a say, a $100 TV, in 10 years.
- 7% Growth – $100 investment today becomes $196.7 in 10 years
- 7% Inflation – $100 TV today costs $196.7 in 10 years
So inflation makes things cost more, thus in effect shrinking the worth of your money. Inflation makes the cost of goods increase in compounding mode, just like how investment growth makes your investment grow in compounding mode, but in a negative way.
Another largely ignored result of compounding is credit card bills. Credit card interest rate stands at 24%p.a. This is compounding at work, for the banks that is! The sword is in their hands and the sharp end is pointing at you!
Compounding is a great slave but a terrible master. Make sure compounding works for you, not against you.
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