Reinvestment of earnings and returns has been the greatest weapon of all successful investors and businessmen. One can grow his wealth exponentially by using the power of this phenomenon which is termed compounding. It is one of the greatest mathematical concepts of all time. In compounding, it can be said that the growth of wealth is directly proportional to the amount of time because the longer one holds his investments and keeps reinvesting his earning, the more his/her wealth grows over time. Compounding in the Cryptocurrency world works no differently as people earn from rising in value of assets as well as from dividends or block rewards paid by some cryptocurrencies which can be reinvested to earn compound interest. So, let us learn more about reinvesting and compounding causes.
Compound interests is the eighth wonder of the world. He who understands it, earns it… he who doesn’t… pays it - Albert Einstein
So, what exactly is Compounding?
Compounding is basically the process of increasing the value of an asset by earning interest on both initial principles as well as the accumulated interest over time. In other words, compounding is a phenomenon in which an investment generates earnings, which are then reinvested to generate its own earnings. Compounding is the direct realization of the time value of money (TMV) concept which is also known as compound interest. Compounding amplifies the growth of your working money and maximizes the earning potential of your investment.
How to calculate compound interest?
Compound interest is a mathematical concept that can be calculated by the given formula:
P (1 + r/n) (nt) - P
P = Initial investment (Principal amount).
r = Annual rate of interest.
n = number of times interest is compounded per year.
t = number of years for which money is invested.
To illustrate how compounding works, let us consider an example.
Suppose, you buy 1000 coins of a cryptocurrency that pays 10% dividend semi-annually, meaning you receive a payment of 50 coins twice a year as a dividend. According to simple interest, you will simply receive two payments of 50 coins per year. But, what if you apply the phenomenon of compounding and reinvest the first dividend payment as soon as you receive it, your base investment rises from 1000 coins to 1050 coins for the remaining 6 months span. The next time, you will receive 5% interest on 1050 coins and thus you will receive 52.5 coins as the next dividend payment. That is 2.5 coins extra from the previous dividend payment.
It may not seem like much, but it makes a huge difference over time. Considering simple/nominal interest, it would take around 10 years to double your investment, but by using the concept of compound interest, it would only take about 7 years.
To calculate compound interest on your investment, you can use the above formula or use the calculators.
Factors affecting compound effect
Compounding depends on various factors. Some of the important factors which determine how one’s money will compound over time are:
Initial investment and addition of supplementary funds to the initial investment.
Amount of time for which investment is made. Longer the investment period, more is the growth in wealth.
Type of investment and its scope of profit. It may be in cryptocurrencies, stock market, bank savings account, etc.
Price fluctuation or volatility of the invested asset. Investment in cryptocurrencies is slightly risky as compared to stock markets etc as the market is more volatile. But, it's often said, “higher the risk, higher is the reward”.
Rate of interest, dividend rate, and ROI.
The frequency of interest is compounded per year. It can be annually, semi-annually, 6 months/year, 12 months/year, etc.