Investing 101 - What is investing?
What is Investing?
Investing is when you are expecting a return after putting time or money into something, typically for a long period of time.
People will typically invest towards a goal such as retirement or their kids college tuition. The goal of investing is to generate income and increase the value of it over time.
Investing is different from saving or trading. Savings are sometimes guaranteed and investments are not. Compared to investing, trading involves buying and selling stocks on a more regular basis.
What is Compound Interest?
According to Merriam-Webster, compound interest is interest computed on the sum of an original principal and accrued interest.
To first understand compound interest, lets go over simple interest.
Simple interest is the interest earned on the original principal only.
Example – Simple Interest
Bob invests $10,000 in a savings account with 5% simple interest for 3 years. The interest you earn each year is 5% x $10,000, which is $500. After 3 years, you would earn $1,500 ($500 x 3 years).
Simple Interest Calculation over 3 years:
Year 1: $10,000 x 5% = $500
Year 2: $10,000 x 5% = $500
Year 3: $10,000 x 5% = $500
In total Bob earned interest of –
$500 + $500 + $500 = $1,500
Bob earned $1,500 in simple interest.
Example – Compound Interest
Instead of investing in a savings account with simple interest, Bob invests $10,000 in a savings account with compound interest (compounded annually) for 3 years.
After the first year, Bob would earn the same amount of interest as he did in his simple interest account ($500).
After the second year (because it’s compounded), the interest would be 5% x $10,500, which is $525. This would give Bob a total of $11,025. Compound interest takes into account your principal and the interest that you have previously incurred. In this case, that would be Bob’s original investment of $10,000 and the interest that he earned in the first year, $500.
After the third year, the interest would be 5% * $11,025, which is $551.25.
Compound interest calculation over 3 years:
Year 1: $10,000 x 5% = $500
Year 1 Total: $10,000 + $500 = $10,500
Year 2: $10,500 * 5% = $525
Year 2 Total: $10,500 + $525 = $11,025
Year 3: $11,025 * 5% = $551.25
Year 3 Total: $11,025 + $551.25 = $11,576.25
In total Bob earned interest of –
$500 + $525 + $551.25 = $1,576.25
Bob earned $1,576.25 in compound interest
Bob earned more with compound interest than he did with simple interest.
Compound interest total = $1,576.25
Simple interest total = $1,500
Total difference = $76.25
Bob earned an extra $76.25 more by investing with compound interest.
The earlier you start investing, the better. Compound interest works best when you start early because it gives you more time for your investment to accumulate interest and grow.
Warren Buffet has stated that the single most powerful factor behind his investing success is “compound interest” and Albert Einstein stated that compound interest is the eighth wonder of the world.
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