What is the composed interest?
Compound interest is a financial force that can grow your savings exponentially. Unlike simple interest, which is calculated on the initial investment and does not generate new interest, Compound interest reinvests profits, increasing your capital and generating a snowball effect.
Why doesn’t investing in the stock market necessarily generate compound interest?
In the stock market, profits are not automatically reinvested, which limits the potential for compound interest. If you withdraw your earnings instead of reinvesting them, your investment will remain the same, without the multiplier effect of compound interest.
The problem in the stock market is that it invests in securities for which an increase in price is expected, therefore compound interest is not generated if it maintains a static investment portfolio even if the value of the securities purchased increases. A profit is generated, but not from compound interest.
A strategy that could generate something similar to compound interest in the stock market is that each time there is a profit, the position is liquidated and papers are acquired that also generate a profit. Needless to say, nothing guarantees that this strategy will always be a winner.
How to achieve compound interest
By definition, interest is the cost of money. Really only lending your money (either to the government in the form of cetes, to banks with promissory notes, Sofipos, Fibras, etc.) is what can generate compound interest. To take advantage of it, you must reinvest your profits instead of withdrawing them. As the capital grows, your profits are calculated on a larger basis, increasing faster and faster.
Example:
Suppose you invest 10,000 pesos at an interest rate of 10% per year. After one year, you earn $1,000. If you reinvest this $1,000, instead of withdrawing it, your investment for next year will be $11,000. Now, you will earn $1,100 instead of $1,000, and so on.
compound interest formula
The formula to calculate compound interest is:
Cf = Ci (1+i)ⁿ
Where,
- Cf is the Final Capital.
- Ci is the initial capital.
- i is the interest rate.
- n is the time the investment is maintained.
How compound interest affects your savings
Compound interest can grow your savings exponentially. Imagine that you invest $10,000 at a rate of 7% per year. After 20 years, you will have $38,696.84. At age 25, you will reach $54,274.33. Compound interest works like a snowball, growing faster over time.