Skip links

How to become financially independent 13: Law of Compounding effect

It is said that like attracts like, and money is no different. Einstein called the law of compounding the 8th wonder of the world. He believed it was a law; a universal principle that can be observed, well, universally.  Reaching your goals is achieved by the daily effort you put into what you do, not by some magic success formula, new miracle product, or undiscovered Internet business. Every big success is made up of little successes, each building on the previous and compounding over time.
Compound interest is interest paid on the initial principal as well as the accumulated interest on money you have borrowed or invested. Compound interest is like double chocolate topping for your savings. You earn interest on the money you deposit, and on the interest you have already earned – so you earn interest on interest. A savings account paying monthly interest is an example of an account that earns compound interest.

Compound interest is different from simple interest. With simple interest, interest is paid at the end of a specified term, although if the term is more than 12 months, interest may be paid annually. Not all financial institutions treat cash investments the same way. Some compound interest monthly, others quarterly or even annually. Some charge fees, others don’t therefore carry out thorough research before opening a savings or investment account to be sure of what you can expect in the long run.
The difference between becoming fabulously rich, happy and healthy or broke, depressed and unhealthy is the choices you make throughout your life. Our lives are a mirror image of the decisions we make each day. Success comes from making a series of good decisions over time while failure comes from making a series of poor decisions over time.

Compounding effect is therefore the principle of reaping huge rewards from a series of small, smart choices. Success is earned in the moment to moment decisions that in themselves make no visible difference whatsoever, but the accumulated compounding effect is profound.

Compounding requires two things to work: the reinvestment of earnings and time. Compound interest can help your initial investment grow exponentially. For younger investors, it is the greatest investing tool possible, and the number one argument for starting as early as possible. In order for the compound effect to work, you need to be patient, you need as long a time perspective as possible. People who think hour to hour, earn a wage and spend it. 

Compounding gives momentum, and works moving forwards or backwards. Ever growing percentages of money attract ever-increasing amounts of money. Ever growing debt attracts ever-increasing amounts of debt. In fact, the rich have a problem with too much money: they can’t reinvest it fast enough, because compounding is compounding on compounding, and because they reinvest it, more money comes in. Let compounding work for you, don’t keep changing all the time.

Leave a comment

This site uses Akismet to reduce spam. Learn how your comment data is processed.