Compounding in Stock Investing

Compounding can be referred to as the process whereby an asset’s earnings, generated from other capital interests, are reinvested to generate more interest or gains over time. Basically, your investment generates interests and those interests generate interests of their own. Some people would like to think of compound interest as your money making money on your behalf. A common example is seen in holding single stock over a long period of time with constant reinvestment of other capital gains, thereby, creating a compounding effect. Many assets tend to grow rapidly over time with compounding. The trick is, the longer you let your investment grow the more interests it generates.   

For example, say you currently have an investment worth $12,000 with a 5% annual interest which would only fetch you about $600 per year. Investing that amount for five years would generate a total interest of $3000. This is on average; you can increase the interest rate to 10% through compounding.

Compounding is not limited to stocks alone, as it can be applied in other investment vehicles and bank savings accounts. Regardless of what investment vehicle is involved, the main purpose of compounding is to generate more interest in an asset and ensure that the asset remains in near-high always. Compound interests work best in bank savings accounts, certificates of deposits (CDs) and bonds.

On the flip side, in as much as compounding could be a great means to financial gain or wealth generation in the long run, investing in the wrong asset could cause the reverse to be the case. Basically, your investments could suffer regardless of how much you are willing to reinvest in it if the company isn’t performing well. Holding a stock that fails to appreciate over time could only be detrimental for the investor. Some other investors fail at compounding because they don’t put in much effort to keep their investment near enough to the highs, any slight loss would take them to lower levels and they may struggle to get back to the former position.

The major mistake many stock investors make is to simply ‘copy and paste’ investment strategies of big-shot investors like Warren Buffet. That is, investing in stocks of big companies that have the tendencies to keep growing for a long period of time. By doing this, such investors miss out on the opportunity of investing in smaller companies which also have great potentials to grow over a long period of time like Apple (APPL), Amazon (AMZN), Microsoft (MSFT), or Facebook (FB).

A better approach investors can take to generate compound interest on their stock investments would be to carefully research the market and find out company stocks that have the tendency to appreciate over time. In addition to this, a stock investor may decide to consider their investment portfolio as a single asset that they are growing at a compound rate, with a target of keeping it near high for a long period of time.

How to calculate the compound interest on an investment:

Start by multiplying the start amount (principal) of the original investment by the interest annual interest rate return on that investment. Then add that number to the principal.  

EX,  A 5 percent return on a $10,000.00 investment will return 

(5/100) * 10,000. = 500.

Therefore, a $10,000 investment will return 500 + $10,000 and for the next year, we will use the same step, but now we will have to calculate the 5 percent of 10,500 using this same step. We will continue to do this for the number of years invested.