Have you heard the saying that it takes money to make money? Perhaps you’ve wondered why people with “old” money have a good chance of keeping up with or surpassing today’s go-getters. It all comes down to compounding.
We can look at this in simple terms, but if we want to find out where the money really is, we may have to dig a bit deeper. Let’s see why money makes money and grows exponentially.
Most of us are still looking to save up enough ready cash to get ahead of the curve. And the majority will be looking at fixed interest accounts because they aren’t yet ready to take on the risks inherent in stocks. Using a simple online calculator, you can calculate your interest on these deposits and take compounding into account.
But what’s compound interest? It’s really very easy to understand. If you have an interest-bearing account, the interest is paid out at intervals and becomes part of the principal amount you initially invested. When it’s time for interest to be calculated again, the full principal amount plus interest already received is used as a baseline to determine how much you should get.
Building wealth is a long-term business. Although a tiny percentage of people can get rich quickly, most schemes that sound too good to be true are probably just that. Remember, if there was such a thing as easy money, everyone would be rich, and since not everyone is rich, it’s safe to assume that becoming wealthy requires you to be in it for the long term.
While interest, and compounding, will grow your money in absolute terms, you need to be aware that in real terms, your purchasing power might actually be decreasing. Even so, spare a thought for the classic example of a person who deposited a penny and compounded it all the way up to 5 million. Money makes money, and the more money it makes, the more it’s able to make!
When we look at investments in stocks and shares, wealth accumulation gets interesting. Stocks are, by definition, risky, but balancing your portfolio across companies and asset classes means that when some lose, others win.
Meanwhile, some of your investments pay out dividends which you reinvest. More money invested means more money earned over time and a faster way to grow your value. But because stocks and shares are risky and can fluctuate, you do need to spread risk and be ready to ride out storms.
Recoveries from the worst crashes can take anything from four months to seven years, but the point is that they do recover. It serves to illustrate the point that genuine investment and wealth creation are longer-term goals. And much of it comes down to the power of compounding, which explains why “old money” often keeps place perfectly well with “new money” and can even outpace it.