The power of compounding: the eighth wonder of the world
On the other hand, investments can be risky. You can have large swings in the value of investments that can be quite unnerving. Sometimes, the value of investments can remain subdued for a long period of time. But at the same time, in some years, the value of investments can give phenomenal returns. So the question arises, why should you even bother investing in the first place?
The answer lies in the “power of compounding.”
Compounding here refers to the compounding of your money over time and it happens due to compound interest. When you invest your money for one year, it earns some interest. Now, if you do not withdraw that interest but leave it in your account, you start earning interest on interest. In the second year you will be earning interest not only on your initial investment but also on the interest that you earned in the first year.
Compounding is the 8th wonder of the world — Einstein
Compounding creates a chain reaction by generating returns on the returns as long as your money remains invested. Compounding works when you let your money stay invested. It works even better when the interest that you earn on your money is more and delivers exceptional returns when you stay invested for longer periods of time.
The difference between 3 approaches to money
Most financial planning experts will tell you to build a large enough pool of savings that can last for six months of normal living expenses.
Let us look at an example.
Three friends Peter, John and Sam all had AED 100,000. Peter was very scared of investing and left his money in bank deposits where interest rates are about 1% per annum. John was scared of stocks and wanted to invest only in bonds, whereas Sam realized that if he does not need the money in the short to medium term, he can invest it in stocks for higher returns.
The difference in the final values is staggering. Sam may have endured more ups and downs but because he wanted to stay invested for the long-term, he took more risks and received far higher returns. If this was the retirement pool of money, Sam will retire far more comfortably and enjoy a better quality of life compared to his two friends.
