High return means that you need to take a higher risk. It is a philosophy that most investors believe in when they start to build a portfolio in the market. It seems to be the only way in which one can build wealth. However, this is not true.
Compounding is a powerful force, and when this gets applied to your investment, you understand how it makes you rich. The principle of the compound interest is to earn interest on your invested income. When you use the power of compounding, you see your money growing at an accelerated rate. If you invest small amounts of money regularly in the market, then you can get a very high return if you stay invested for a long time. It happens because of the power of compounding.
Anyone can make use of the power of compounding. All that it needs is discipline.
The factors that determine your return when you use the power of compounding
There are three things that will determine how much you will be able to earn because of the power of compounding:
· The interest rate that gets paid out of the profit that you make on your investment. If you are investing in stocks, then the profit and the dividends that you earn will decide the compounding effect.
· How long you stay invested will determine how much wealth you will be able to create.
· Staying invested for a longer time lets you save on taxes. The tax that gets saved can be invested to make more returns.
Compound interest and the time value of money
The compound interest principle can be understood when you understand the time value of money. Find this explanation useful when you trade on Bitcoin. It states that the value of money changes as per when it is received. Here is an example of this. Suppose you receive $100 today. You will prefer getting it today than to wait for some years to get the money. The money that you have now can be invested to get interested and dividend on your investment. You can also spend some of the money to pay off your debts or to buy things that you need. If you postpone the receipt of money, then this is a loss which in the economic term is the opportunity cost.
The time value of money should be used to determine how much you need to save now and at what rate of interest to receive the wealth that you need after a few years. Once you understand the principle of time value and compounding it lets you plan out your savings to get the return that you desire.