Compound Interest can turn a good investment into a great investment, and understanding it is very important as a trader. Considered as a wise investment strategy, compound interest is based on continuous reinvestment, rather than instantly withdrawing profits, so is suited to those looking for a long-term plan. It is an important feature in finance as it can see an exponential growth of even small amounts over compounding periods.
Here’s our guide to take you through what compound interest is and how it can make money when investing.
What Is Compound Interest?
Compound interest is the process in which additional payments are earned from the initial amount, any further deposits and the proceeding accumulated earnings, based on the idea of reinvestment to generate additional earnings. This differs from linear simple interest, where only the original amount earns interest over each period of time. The longer the duration of the investment, the bigger the impact of compound interest and the greater number of compounding periods.
Compound Interest and Trading
Compound interest is part of many traders’ investment strategies. There are some corporations that offer a compound-based reinvestment plan, that means investors can use their cash dividends to reinvest and purchase additional assets. As a result, the returns to the investor are compounding as the more reinvesting, the greater number of shares and the more future income from the dividend pay-outs.
The benefit of compound interest also works when investors, and mainly day traders, have a trading account as their main account, which holds all the securities, cash or other holdings for investment. In the trading account, the compound interest lets the money do the work for the investor and their trading system, taking into account the win rate, the average position size and the average reward to risk ratio. Day traders, particularly, can profit from reinvesting their daily income and enhance their returns with a compound interest-based trading account, instead of withdrawing any revenue generated at the end of each day.
Compound interest can also be advantageous when forex trading or CFD trading, as the positive outcomes can be immensely magnified, especially when trading in currency pairs that involve a significant difference in interest rates between the two currencies.
Factors to Consider with Compound Interest
There are several factors to take into consideration when involving compound interest into your investment strategy.
Patience is a key component when it comes to using the principle of compound interest. It may seem slow, but 90% of the trading and investment journey using compound interest will appear as if not many earnings have been generated. However, once the trading account hits a certain size, this is when traders can see a real rise in their returns. So, it is important to remember not to give up and change trading systems before this boom happens. It is a long-term investment plan after all, and although it may start off slow, it is a reliable way to increase your capital and over a long period of time can result in a rather large amount in your account.
The next thing to then consider is consistency, which goes alongside patience. As a trader, a consistence performance, deposits and reinvestments, means that you will continuously benefit from the compound interest on the earnings in your account.
Another factor to consider is the interest rate of the account in which the compounding is taking place. In general, a higher rate means that capital in the account will grow faster. But as mentioned before, this should be part of a long-term investment. So, in fact, the length of time and number of compounding periods should also be taken into account, and therefore can still work with a lower rate. The initial deposit of money, however, does not have such a huge impact on the compounding. The compounding effect always works in the same way and has potential to generate large accumulated amounts, and is particularly effective with a high interest rate and a long period of time. An online compound interest calculator can help with the workings and research into the rates and period of time when developing an investment strategy.
So, for investors looking to expand their trading experience, it is important to understand the impact of compound interest when considering their investment strategy, and what it can do to generate more income, reinvest in more shares, and affect their forex and CFD trades.