Compounding is the addition of two or more interest rates that are paid at intervals. This practice helps limit the risk of an investment over time. Compounding can only occur if the invested funds are available to handle daily interest payments and will only compound once they are returned to an investor. If the funds are left in the account for a sustained period, they may compound faster than these rules allow, and accordingly, this activity can generate significant returns. Compounding must be taken into account when making an investment decision.
The objective of this investment option is to apply excess interest to update the principal and thus provide a higher rate of return on the investment. To accomplish this, you must invest excess interest income in a common stock and have another fund invest the same amount in cash or fixed-income securities that are not intended to be long-term investments. Since the common stock will be returned to you, a rise in its value does not compound but will only affect your taxable income at the time of payout. Consequently, there are no gains or losses to report if you retain these securities within 120 days following their purchase date.
Benefits Of Compounding
1. Reduce risk.
By compounding, you avoid the risks of being completely invested in a volatile market. If you are completely invested, you may lose some or all of your capital if the market declines. It is easier to sustain long-term growth if you maintain a portion of your capital in cash or fixed-income securities that you can use to purchase additional investments when market values are low.
2. Minimize taxes.
Because valuable tax deductions and benefits accrue over the long term, it is important to have a portion of your assets invested in a fixed-income fund that will maintain its value. In contrast, the other half of your assets are deployed into equity funds. A tax shield will help reduce the amount of annual taxable income and lessen future capital gains taxation.
3. Increase earnings.
By compounding, you increase your investment earnings and enhance the growth of your capital. For example, increase your cash capital to $1,000 and earn a 10% annualized return. If your investments are invested in equities, they will grow to $10,000 annually. However, if you have $1,000 invested in common stock and the same return on market value is gained, both investments will total $11,000. One important consideration is the interest income generated by the common stock investment over time. If you can earn an annual return of 8% from this investment, it will compound for ten or 11 years.
4. Maximize gains.
When you invest in common stock, you can more accurately forecast future earnings and capital gains because the common share is direct company ownership. How quickly an investment will grow depends on how robust your economy and business operations are. The more robust your economy, the faster an investment will grow if you properly use it to benefit from compounding returns over time.
5. Add more capital.
If you can earn a 10% annualized return on your investments, you can increase your capital to double your initial investment after 12 years. It will provide you with a sizable cash cushion in case of an emergency and allow you to use the funds available for another investment opportunity.
6. Build cash reserves.
Through compounding, you can create a sizable cash reserve that remains liquid and readily available for personal use, especially if an emergency arises. The cash reserve can be invested in short-term investments or used to replenish the principal of your other investments. It will also provide a buffer in case of a drop in the market.
7. Defer income.
The dividends and interest earned over time by the stock investment will be taxed once you receive cash or the shares. By investing in a fixed-income fund, the funds accrued on your investment and eventually paid out will only be taxable if you retain them for at least 120 days following their purchase date.
8. Reduce tax liability in retirement.
By investing in common stock, you can defer income taxation until much later in life and live off these gains without paying additional taxes on these earnings. Keeping your investments within 120 days following the purchase date reduces the taxes paid on these gains and allows them to accrue for decades.
9. Provide an auto-pilot strategy.
You can place most of your investment income into the common stock fund and allow it to compound for ten years or more. Then, move this money into a permanent investment, such as a fixed-income fund, for continued growth and preservation of capital over multiple years or decades. It will allow you to earn the greatest gains from an otherwise relatively safe and secure investment.
10. Reduce the volatility of your total portfolio.
Intelligent management of risk can assist you in maximizing your returns on investments over time and help build a more stable investment portfolio. By placing most of your assets into common stock investments, you can reduce risk by diversifying your investments and regularly rebalancing your portfolio to match market conditions. It will allow you to grow a steady income stream and increase the value of your capital over time without having to make dramatic changes to your strategy or be overly concerned about short-term fluctuations in the market or economy.
Therefore, with compounding, the investor can benefit from increasing investment returns over time and reduce their reliance on timing the market to maximize profits.
Many advantages accrue to investor who uses compounding to grow their wealth. Compounding allows for greater earnings on money invested and a greater return on capital over an extended period. The annual rate of return will depend on the expected rate of return and the interest rate earned by your money within your investment accounts.