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Compound interest arises once you start earning interest on your original investment also as on interest that you simply earned in previous years or Financial Planners.

Here is how it works:

Suppose Jack invests $1000 in a bank account paying 10% interest for three years. Jack doesn't make any additional deposits during this era . His investment will grow as follows:

Scenario 1: Jack does not withdraw the interest

Year, Start value, Interest, End value

1, $1000, $100, $1100

2, $1100, $110, $1210

3, $1210, $121, $1331

Scenario 2: Jack withdraws the interest every year

Year, Start value, Interest withdrawal, End value

1, $1000, $100, $1000

2, $1000, $100, $1000

3, $1000, $100, $1000

In year 1, the investment earns $100 interest. By reinvesting the interest (Scenario 1), Jack will have $1100 in his bank account.

At the top of year 2, his investment are going to be worth $1210. Rather than earning $100 like in year 1, the investment earns an additional $10 because the $100 interest gained in year 1 will also grow by 10%.

In year three, the account gains $11 interest on the $110 interest earned in year 2 leaving a balance of $1331 at the end of year 3.

By withdrawing the interest per annum (Scenario 2), Jack won't enjoy compounding or interest on interest earnings.

Compounding only works if you reinvest your earnings.

This brings us to another important point:

Compound interest features a greater effect over the future .

Let's assume that Jack (who is 50 years old) invested his money at age 30. His twin brother (Jackie) only started investing at age 35. Like Jack, he also invested $1000 at 10% interest.

What do their respective bank balances show at age 50?

Jack's balance: $6727

Jackie's balance: $4177

Difference: $2550

Both brothers invested an equivalent amount at identical interest rates. But by leaving his account to grow for a extended period of your time , Jack managed to realize an additional $2550.

The longer you leave your investment the greater the compound interest effect, which is why the experts encourage you to start saving/investing as early as possible.

Beware the dark side of compounding.

Compounding is what all investors are after, but negative compounding is a major cause for concern.

The power of compounding is harnessed when your investments are exposed to positive returns each and every year. A $1000 in a mutual fund realising 15% every year will grow to $2011, $4046 and $16367 after 5, 10 and 20 years respectively.

The only problem is that negative growth periods can wreck your gains. And if you have consecutive periods of negative growth, consider your financial plans screwed. A $1000 investment that loses 50% of its value will have to grow 100% just too break even.

Two key lessons:

Successful investors actively manage their investments to offset the effects of negative compounding.

You will have to endure negative compounding with a buy and hold strategy. Seek out businesses that pay you passive income and capitalise on customer needs, rather than expose your returns to the tides of economic cycles.

Income creation is the new wealth creation. Do you want to learn how to build two powerful income streams that enable you to live your ideal lifestyle?

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