The Magic of Compounding

What is compounding?

Albert Einstein once said “Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”

Compounding occurs when the proceeds from an investment are reinvested over and over again to generate additional returns, which causes the investment to get bigger at a faster and faster rate over time.

The easiest way to understand compounding is to think of it as a snowball rolling down a high hill. It starts small, but then gets bigger and bigger as it rolls down the hill, because as it grows, the amount of snow that it picks up grows too. This makes the snowball get bigger at a faster and faster rate.

Let’s look at an example – if we doubled $1 thirty times, how much money would we get? More than one billion dollars, that’s a lot of money!

The stock market is such a powerful wealth-building tool because it compounds an investor’s money over time. The longer you keep the money the better for your return on investment.

To break it down, let’s get back to our example of Best Coffee Shop, where each new location costs $10,000 to build. The company’s original plan was to raise $100,000 from public investors and open up one new store each year.

Let’s assume that Natalie, Ethan and Lauren make a decision to reject that plan and instead, they decide to open up new stores by reinvesting all of the company’s annual earnings to build as many stores as possible.

In year one, Best Coffee Shop earned $20,000 in earnings. Natalie, Ethan, and Lauren use this money to create two new stores the next year.

In year 2, Best Coffee Shop has 3 stores open, which provides $60,000 in yearly earnings. So Natalie, Ethan and Lauren decide to open up 6 new stores with the earnings the following year.

In year 3, Best Coffee Shop has 9 stores open, which would provide $180,000 in earnings, allowing them to open up 18 new stores the next year. This example is to show you that the earnings are growing so fast thanks to compounding.

What is a “bull market” and a “bear market”?

The term “bull market” is from the way that a bull attacks – bulls thrust their horns in an upward motion. A bull market is when market prices are rising, generally by 20% or more from their recent low and are expected to continue going up. Bull markets have a tendency to last for long periods of time.

A bear market is when market prices fall by 20% or more from their recent high. A bear market can occur for any length of time, since there have been times when a bear market lasted a couple of weeks, but also times when it lasted for decades. The name “bear market” derives from the way that a bear attacks its prey – by swiping its paws in a downward motion.

What is a correction and a sideways market?

A correction describes falling market prices. Corrections in the stock market tend to be short-lived and usually last around a few months.

A sideways market is when market prices trade within a fairly stable range for a long period of time.

Even though these 4 terms are most commonly associated with the stock market, they occur in other types of markets like bonds, precious metals, cryptocurrencies, real estate and other types of assets.

The Rule 72

The Rule 72 is another rule of thumb to keep in mind when you start your investing adventure and want to estimate how many years it would possibly take you to double your money, you should get acquainted with it. The rule 72 is a simple and quick way to find out how many years it would take your capital to double the value. This rule is not 100% accurate, however, it enables you to make an estimation which may influence your ultimate investing decision.

Divide 72 by the annual interest rate and the result is the number of years that it will take you to double your money.

Let’s take a look an example: If you earn 10% annualized return, it will take you about 7.2 years to double your money (72 divided by 10 = 7.2)

Top takeaways for a beginner investor to think about

• Saving is just as important as investing

If your saving’s rate is relatively low, you can’t start investing. You need to save money for no reason in order to be able to invest a chunk of that money. 

• Pay off your debts

If you have debt, make it your priority to pay it off asap. Debt is a burden that not only influences your financial life, but more importantly it brings  stress and uncertainty to your personal life. 

• Track your income and expenses 

Now, who likes to get a hot latte with some delicious almond milk and whipped cream on top? Probably most of us, but hey, if you get that on a daily basis, each time you buy it you see your $5 walking away forever. Imagine how much money you could save up, then invest and then reinvest, if you kept that money on you. 

• Think of what your investment philosophy would be: Passive or active?

If you’re a beginner a passive method could be more simple and clear to start with. A passive style of investing seems simpler because investors choose to allocate money to index funds that are broadly based and have defined fundamental rules. For example a passive investor may choose to invest in mutual funds or an ETF, commonly known as an exchange-traded fund that holds all publicly traded companies in the U.S. The simplicity about such a style is that you would own a small chunk of every American stock without picking individual stocks. Conversely, active investing requires investors to do the math and complete research to place their own stock bets. In this case the S&P 500 would be their benchmark to beat.

• Compound interest can be a wonderful ally or the worst nightmare

If you invest and hold on to your investments, most certainly you’ll experience how your money compounds and works to make you even more money. However, if you carry debt and then take another loan to pay for your everyday costs, then compounding could be a curse to your personal finances, making the spiral of debts grow each day.  

• Investing isn’t just for the rich

You don’t need millions to start investing, you could start with a tiny amount just to kick it off. Any amount that enables you to purchase stock is enough to start with. There is a common conviction that investing in the stock market is reserved only for fancy powerful rich investors, but this is not the case at all. If you still feel intimidated, you may want to consider investing in index funds first, so you don’t feel overwhelmed with pressure to pick individual stocks. The point is, there are various options and most of them are easier than they seem. Just like you already found out in our investing series for beginners – you’re just one step away from starting. 

• Don’t let “analysis paralysis” keep you from getting started

Don’t overthink it! It’s great that you feel responsible enough to make sure your investing strategy and portfolio are the right ones to grow your money, however making it too complicated and waiting for the perfect moment and the perfect stock is pointless. You just have to give it a try. 

• There is no such thing as the “perfect” time to invest

Always, there will be people telling you that this is not the right time to invest! However, you shouldn’t be bothered because there is always a right time to start investing and it’s never too late to start. 

• Time in the market is more important than timing the market

There are dozens of so-called experts who will gladly share their secrets on how to time the market and outsmart the rest of investors. The truth is, you need patience and time to invest.

• Investing, not trading

Don’t play a game of trading if you truly look to compound wealth with your stock market investments. If a stock rises rapidly one day and you are tempted to sell it so you earn a tiny capital gain, think twice if this is what you really want to do. Shares rise and fall every day, but a small gain does not provide a satisfactory result when it comes to investing long-term with high returns on the horizon. 

• Get started ASAP

A common thing for the majority of people in the world is to think that “it’s too late to start something”. That is not true – as we established, there’s never the perfect time for starting something from scratch, especially when you don’t feel qualified or competent within the area. Nevertheless, there is always time and potential to catch up and start doing it. You just have to take the first step and take a chance.

Congratulations on finishing the Stock Market 101 series for beginner investors. If you’re looking for more advanced resources on stock market and other kinds of investing, we have a vast amount of free academic resources and podcasts you can learn from.