Nobody wants their finances to grow in a straight line (too slow, and inflation really hurts), so let’s continue this series with a look at a faster way to grow your money … one that is well covered in mainstream personal finance blogs:
The Compound Curve
When we do one simple thing [AJC: again, ignoring the effects of inflation], the whole picture changes dramatically:
If, instead of withdrawing/spending the interest earned on the CD, we ask the bank to reinvest the interest then we create an effect known as compounding. Where both the principle (i.e. the lump sum that you originally deposited) and the interest (then the interest on the interest and so on …) earn interest. The effect, as you can see, can be quite powerful … slow, but powerful.
In fact, ‘urban legend’ has Albert Einstein calling compounding “the most powerful force in the Universe” … urban legend because Einstein would never have called such a relatively [pun intended] slow geometric progression ‘powerful’ when he had nuclear reactivity to play with (a far quicker and more dramatic form of compounding).
Be that as it may, compounding is something well understood, but always remember that it is only powerful to the extent that it may keep you out of the ‘poor house’ – but, not by much – hence, compounding is really only a basic (but necessary!) Making Money 101 saving strategy:
– without it, you don’t get to first base, financially-speaking, but
– with it, that’s about all you do.
You can – and probably already do, to a greater or lesser degree – apply the power of compounding to your job/profession (be it as paid employee or paid consultant) when you reinvest some of your earnings into investments such as mutual funds (e.g. via your 401k), direct stocks, and real-estate … and, of course, reinvest (instead of withdraw and spend) the dividends (a.ka.a ‘profits’) from those investments.