The purpose of investing is to generate income. Different trading strategies can be used to achieve this goal. A trading strategy is a complex algorithm of actions that has been practiced and honed for years. But significant results can be achieved without seriously complicating the approach to investment. The long-known compound interest will help in this.

Many people call the principle of compound interest magic. In fact, this is not magic, but a really working, mathematically cool principle. In this article we will try to figure out how compound interest works and why it is so important for an investor.

## The principle of operation of compound interest

Compound interest is the interest that is accrued on the initial amount of investments and on the interest accumulated over previous periods. That is, the interest becomes complicated due to reinvestment of income (received interest).

Einstein's quote about compound interest

In simple words, the effect of compound interest is that the interest you earn on savings /investments begin to bring interest on their own, that is, you get "interest on interest". The simplest way to illustrate its essence of compound interest is with an example of a bank deposit.

Example. Suppose an investor has 10,000 dollars, he places them on a bank deposit at a rate of 10% per annum for 1 year. For the first year, he will have an amount of 11,000 dollars on his account. Further, if these funds are reinvested, placed on deposit again, then for the second year the investor will receive (11,000 + (11,000 dollars * 10%)) = 12.100 dollars.

There is a formula for calculating the total amount of accumulated capital:

We use this formula to calculate from our example:

A - final amount

P - initial principal balance

r - interest rate

n - number of times interest applied per time period

t - number of time periods elapsed

Future amount of capital = 10 000*(1+0,1)7 = 19 487 dollars.

After 20 years, the amount of capital = 10 000*(1+0,1)20 = 62 275 dollars.

As the percentage part grows, the growth of your capital will go faster - grow exponentially over time. Precisely, TIME plays a major role in this mechanism.

In the first years of accumulation, it may seem that you earn only a modest amount of interest. But, if this process is maintained for a long period of time, every year the effect of the compound interest will grow exponentially until it exceeds the initial capital and will not be responsible for the formation of most of your income.

The principle of operation of compound interest is one of the best explanations of why saving for retirement is worth starting at a young age. Even with a small amount of start-up capital, but provided that proper discipline is maintained, over time, most of the accumulated amount can be "interest on interest".

**Read more:**** P/E Ratio: what it is needed for and how it is calculated**

## How to apply compound interest in investing

In the stock market, you can invest in various securities. The basic variant of investment instruments are stocks, bonds, ETFs. The principle of operation of each tool is different, but their essence is that they can bring income to their owners:

- income from the growth of the price of securities (stocks and ETFs),
- dividend payments (shares),
- regular coupon payments (bonds),
- regular depreciation payments (on bonds).

The first component of investment income - earnings on the exchange value of the paper - is not guaranteed and can be significantly stretched over time. The compound interest scheme works best when reinvesting regular payments. In order for the compound interest scheme to work, systematic income must be reinvested, that is, to buy "new" investment instruments. Eg:

- the dividends received should be directed to the purchase of shares of promising companies,
- received coupons and amortization payments for the purchase of new issue bonds with a higher interest rate.

That is, the cash flow should not be withdrawn from circulation, but should be put back into operation. In the case of funds (for example, ETFs), dividends and coupons are not paid, but are reinvested by the funds themselves, that is, the mechanism for reinvesting compound interest is already "sewn" into the instrument itself. But this is a dubious advantage, because the investor does not control which securities the periodic income is invested in. In addition, the commission of the management company partially reduces the possible profitability.

It is important to distribute the resulting profit evenly, according to the portfolio structure and the share of each asset in it, applying the rule of diversification. If necessary, rebalance the structure of the investment portfolio. Constant reinvestment in only one paper significantly increases investment risks.

## The benefits of compound interest for the investor

There are a lot of tools for modeling the mechanism of compound interest – starting with the well-known Excel, ending with advanced compound interest calculators. But the principle of their work is the same: initial conditions are set in the form of the amount of capital, the percentage of return on investment, the amount and frequency of deposits, the investment period ... and then there is a standard calculation mechanism.

**Read more:**** How to evaluate growing companies? PEG Ratio**

## Conclusion

Return on investment is the main goal of every investor. Compound interest, as a mechanism for increasing capital over time, is an important tool for a competent investor. Its meaning is that after a certain period of time, the percentages begin to work for themselves. There is no complexity and no magic in this process. The main thing is to launch it into the process of capital accumulation, reinvesting the profits received.

The easiest way to launch a compound interest is through opening a bank deposit with subsequent reinvestment of the interest received. You can also open a ready–made deposit with an already sewn reinvestment mechanism - a bank deposit with interest capitalization. But at the same time, it is worth remembering that the yield on deposits is approximately equal, and often even less than the inflation rate. That is, interest is accumulated, reinvested, capitalized, but the real value of savings may remain at the same level. That is, there is nominally more money, but with an increase in inflation, they can buy the same amount of goods as 1, 2, 3 ... years ago. Much greater profitability and even with a lower level of risk can be obtained by investing in government securities - there are fixed periodic payments that can be reinvested. This is an option for conservative investors. For investors who are loyal to risk, shares can be added to the list of investment instruments. Stocks do not bring stable fixed income, but their potential yield is much higher than bonds.

It is worth noting that investing in the stock market carries increased risks. In order to obtain the desired profit, the investor needs to maintain a balance between potential profitability and risks, and respond to changes in the macroeconomic conditions of the markets. At our free webinars, we introduce investors to the opportunities that the stock market opens up, using our unique method of reasonable investment, based primarily on many years of experience.