In the previous post, we saw how people are feeling about investing. Now it’s time to answer the fundamental question: “Why invest?”. Many people think that investing is to obtain financial freedom, retire early, or more generally become rich overnight if one is lucky enough. To do so, you need to find a company that will surely become a unicorn in the future, but how can anybody be sure about what will happen next?
Money makes money
The above strategy can be summarized as buying something at a low price and selling it at a higher price. However, there is another way to increase your money (almost) surely, but gradually, that is “compounding.” For simplification, imagine you lend $100 to somebody with quarterly 1% interest (i.e., the borrower needs to pay 1% of the borrowed amount every quarter). If you only keep the interest payment under the mattress, the value of your lending only grows linearly, a $1 increase/quarter (B). However, suppose you lend the received interest ($1) to another person. In that case, it will incur an additional 1 cent ($1×1%=$0.01) in the next quarter, and by repeating the same procedure (reinvestment), this interest on interest makes significant differences (A). Benjamin Franklin famously said money makes money, and compounding is the very mechanism behind it.
Note: Assume a quarterly 1% interest rate. This information is not intended as a promise of future performance.
Compounding is the secret to carefree investing
Of course, the above example is an extreme simplification, and you can point out that we cannot receive 1% interest on 1 cent; how can we know the interest rate continues to be at 1%; what about the risk the borrower doesn’t repay the initial $100 in the future, etc. But the most important thing here is to understand the concept of compounding and reinvestment (money makes money), which is the secret of increasing your money steadily with less anxiety.
If you don’t comprehend everything mentioned above, it’s no problem, as we will continue to explain those concepts in various ways in the coming posts. But now, you started to understand the power of compounding. At the same time, new questions have arisen, like; what is the risk of losing your initial investment? Why there are several types of investments (loans, stocks, etc.)? In the next post, we will explain the essence of risk in the context of investing.
Compounding is the way to increase your money gradually but (almost) surely.
Small amount of money makes a significant difference in the long run.