Why Compound Interest Is Very Important To Investors

Compounding interest can help generate large returns over time, and investors are often surprised to learn just how much invested principal can appreciate if returns are reinvested over the long term. Understanding the time value of money and the exponential growth created by compounding are essential for investors looking to optimize their income and wealth allocation.
Investors are by definition foregoing current consumption in exchange for future consumption, so the importance of compounding returns and appropriate retirement savings is usually apparent to them.

Powerful Wealth-Building Mechanism

Compounding interest is a very effective method by which investors build wealth. Capital invested at the start of year one generates a return of some value on an annual basis. Assuming this is a security with a fixed return and no default risk, this annual rate of return is predictable over the life of the investment. Consider a $100 investment bearing 5% interest. If the interest income generated on the principal is removed from the account each year and placed in a separate no-interest account, the account will accumulate $100 after 20 years, and the investor's total assets would be $200. However, if the interest income was reinvested at the same rate, the total assets would be worth over $265 after 20 years.

Exponential Growth

Compounding interest yields exponential growth, meaning dollar returns accelerate with time. This has especially important ramifications for savings and retirement planning. Exponential growth yields the largest returns at the end of the investment's life, which generally corresponds to retirement for most savers. Compound interest builds upon the preceding period's holdings, so there’s no shortcut to speed up the process, assuming constant interest rate and paid in principal. Therefore, delaying the process by a year costs the investor the latent returns from the final year of growth, instead of the first year of growth.

Offsetting Eroding Factors

Exponential growth from compounding interest is also important in mitigating wealth-eroding factors. Inflation is a major source of reducing purchasing power over long time frames. The cost of living is generally expected to rise over future periods, so larger dollar amounts are necessary in retirement to maintain the same level of consumption. The growth acceleration created by compounding helps an investment appreciate even after controlling for declining purchasing power.

Medical treatment is particularly relevant for retirees; the exponential growth of long term accounts is helpful when assessing one's ability to meet his medical expense obligations. Moreover, many residents of developed economies are concerned about the fiscal situations of their government. If higher future tax rates are essential to support these government expenditures, then compounding interest is necessary to make capital saved in the present grow sufficiently into retirement.

Debt and Opportunity Cost

Compounding interest as well works against investors who do not save. When credit generates negative savings, the individual have to pay compounding interest on any disconcerted balances. Such a situation leads to an exponentially growing liability, undesirably impacting an individual's net worth more strictly as time passes. Moreover, the rising interest payments necessary to service the debt can’t be invested, which produces a chance cost as this capital is not being put to work to generate returns.