The Power of Compounding: Why is it Important for Wealth Creation?
Compounding is a fundamental concept in finance that can make a significant difference in achieving your long-term financial goals. It refers to the process of generating earnings from an investment and then reinvesting those earnings to generate additional earnings over time. This compounding effect is particularly powerful for long-term investors, who can benefit from the exponential growth of their investments over time. By reinvesting earnings, you can achieve significant wealth accumulation and take advantage of the time value of money. Earnings can be derived from dividends, interests, or any other form of the income distribution earned in an investment.
Here's an example of how you can use this to your advantage. Assume you have a $20,000 lump-sum investment that earns 10% per year; the $2,000 you would make would increase your total to $22,000. If you earn 10% the following year, you will have $2,200 added to your balance, and so on.
Now, let's use this example to see what happens if you withdraw the return every year or if you don't invest at all.
For illustration purposes only. This projection is not a guarantee of future results and actual income may vary. Investing involves risk.
The table above shows the results of three different investment approaches over a 10-year period. The first way is to reinvest profits and let them grow over time, the second is to withdraw earnings every year, and the third is to save in a bank account.
For the first approach, we can see that after 10 years, the investment with reinvested earnings has grown to $51,875. The second approach which is an investment with withdrawn earnings every year generated a total return of $40,000. The difference between reinvesting and withdrawing is $11,875 or almost 30%, which is a significant amount, particularly over this time frame.
The third approach which is a bank saving account with a 1% annual return has a balance of $16,438.85 factoring in the 3% inflation rate. The sad reality is that when you leave your money in a bank account, you might think that you are keeping your money safe. However, if the inflation rate is higher than the interest rate of your bank (as shown in the third approach: 1% annual return vs 3% inflation rate), the value of your money will decrease over time. Even if you intend to withdraw your returns or portions of them every year, it is still preferable to invest rather than deposit it entirely in a bank.
Another option you could do is simply topping up your current investments, especially now that interest rates in the United States are showing signs of easing. Also, if you are investing monthly, it is best to be consistent. We made an article regarding dollar cost averaging on this link (https://www.expatlifecoaches.com/post/how-you-should-invest-in-volatile-markets).
If you're looking to build long-term wealth, the power of compounding can be a game-changer. Remember, every small step you take towards investing early can make a big difference in the long run. By reinvesting your earnings and letting them grow over time, you can potentially achieve significant gains and reach your financial goals faster. Don't wait any longer to begin investing and saving for your future.
Connect with Astra today to learn more about compounding and other investment opportunities. We provide a wide and diversified selection of products that can be adjusted to the specific requirements of each client. Our financial advisers will guide you toward achieving your financial goals. Discover opportunities and investment strategies for you today. Don’t know where to start? Talk to an Astra adviser.