Compounding is the process of earning interest on both the principal sum and the interest previously earned on that sum. It’s a simple yet powerful concept that can have a big impact on your wealth over time. Let’s discuss what compounding is and the five benefits of using it when investing.

What is it?

Compounding is the process of generating earnings on an asset’s reinvested earnings. In other words, it’s the interest earned on the interest earned on the principal sum. This means that even if you don’t invest any additional money, the money you’ve already put into an investment can grow significantly over time through the magic of compounding.

For example, let’s say you invest $10,000 in a fund that earns 7% per year. After the first year, your investment would be worth $10,700. After the second year, it would be worth $11,449, and so on. The longer your investment is left untouched, the greater the potential for compounding to work its magic.

The five benefits of compounding when investing are:

1. It maximizes returns over time

Compounding is the key to maximizing your returns over time. By reinvesting your earnings, assets can grow at an accelerated rate. Over a longer period of time, it can lead to exponential growth, leading to a much larger return than would otherwise have been possible with a simple interest model.

2. It’s a long-term investing strategy

Compounding is a long-term strategy because it takes time for the investments to generate meaningful earnings. When you invest money into an account with a high interest rate, it may take a few years for a sizeable amount of earnings to emerge. However, once you have hit a certain threshold, investment returns can snowball and really start to increase over time.

3. It reduces the need for additional contributions

With compounding, you don’t need to constantly contribute additional funds in order to generate meaningful returns. By simply allowing your investment to sit and grow over time through compounding, one can begin to see larger gains without the need to work as hard to generate them. This reduces the burden of contributions which is required in other types of investment strategies.

4. It is largely passive

Although this strategy requires long-term patience, it ultimately requires much less effort than actively trading in an investment account. This can be advantageous both for those who are busy and/or not well-versed in trading. Instead of day trading, time can be better spent learning about financial principles and other investment strategies to help build wealth.

5. It can provide a form of passive income

Compounding is important because it can provide another source of income for investors at a given time. With compounding, investors can create a new source of passive income that can continue to grow on its own as they live their lives and work on other things. When an investment is left undisturbed to compound over the long term, it can ultimately provide a healthy return.

Compounding is a powerful and important aspect of investing that can help investors generate significant returns over their lifetimes. Through this strategy, investors are able to generate earnings without requiring active attention in the short term. With patience and discipline, over the long term, compounding can lead to sizable gains that offer passive income streams in the future.