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Why do people invest? Because of what’s known as the “eighth wonder of the world-compounding. In fact, consider it the investor’s best friend.
Why are investors and money managers alike gaga over the concept? Because compounding can make your money grow substantially over a relatively short period of time. When you hear CNBC talking about the compound growth rate of a stock, they mean the exponential rate of growth over several years. In fact, securities analysts review a company’s compounded growth rate of earnings for five years to determine a company’s profitability. Compounding also refers to the growth of an investment from reinvesting any money that is earned. So, your investment earns a return based on the original amount you invested, and on any return already paid.
Compound interest, on the other hand, is the interest earned on the principal plus interest that was earned earlier. Simply put, you get interest on the interest.
For example, if you were able to invest only $100 a month and placed it in a vehicle that produced an average annual return of 6%, you would earn $16,470 within 10 years.
When it comes to investing for the long haul, compounding and time go together like bread and butter. You can understand the power of compounding once you have a clear understanding of the rule of 72, which will tell you how long it will take for an investment to double. Divide 72 by the compound rate (expressed as a whole number) earned by your investment. For example: 72 divided by 9 equals 8. That equation demonstrates that if you placed $1,000 in an investment with an annual compound rate of 9%, it would be worth $2,000, or double its current value in eight years.
To truly gain the value of compounding, start early. It will only make your life easier if you embrace this wonder of the world.
For information on the Dow Jones industrial average and other Dow indexes, go to http://averages.dowjones.com.