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The power of compounding

No matter what position you are in if you understand and embrace this concept you will really start approach money in a different way.

Let's presume you are reviewing your monthly bills and figured that in August you spent 150GBP on pub visits. Money well spent for some pretty tasty IPAs during the hot summer months, you probably think. 

I don't want to be a joy kill but for a moment we assume that you have not spent the 150GBP in August, only killing your thirst with tap water, and instead invested the 150GBP in a stock that pays an annual dividend of about 4%. A quick reminder: a dividend is a money reward, paid annually by the company for entrusting them with your cash. 

In addition, you instructed the bank to reinvest the dividend paid out into the same stock, thereby the money you put in at the start grows each year by 4%, a bit like building a tower, one brick on top of the other. 

Let us wind the clock forward by 20 years in check what has happened to 150GBP invested into the stock with a 4% dividend payment. 

The formula to calculate this is:  (P*(1+i)^n)

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I know it looks terrible but it is actually quite simple: P stands for Principal, which is the amount that you want to invest. The "i" is the interest or dividend % which in our example is 4% and n stands for the number of years, which is 20years.

So the calculation you need to key into an excel spreadsheet would read as follows: (150* (1+4%)^20), giving you a value of 329GBP. This means in 20 twenty years you could have doubled your money, just by giving up the pub for 1 month. It gets even better. Imagine you you save 50GBP each month (or the yearly equivalent of 600GP) going forward and put it into this dividend rocket of yours. After 20 years this discipline will give you a whopping 18,910GBP. Yes, you read right, you can suddenly afford a deposit on a house, flat, or buy a new car just by cutting back on 50GBP a month putting it into an investment where the power of compounding does all the work for you!

Last but not least I want to finish up the example by making you aware of THE RULE OF 72! This very simplified rule comes in handy when you want to know how many years it would take your 150GBP double, given the 4% dividend you get each year. You simply divide 72 by 4, which gives you 18years. 

I use this "rule of thumb" a lot if I need to quickly work out company growth projections or answer questions like "how long would it take us to make twice as much money if we grow x% per year.

You see the power of compounding is awesome and even works with smaller amounts. It is a nice way to make money work for you and not the other way around. Cheers to that!

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