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Understand the concept of compounding and its impact on returns from "summary" of The Four Pillars of Investing: Lessons for Building a Winning Portfolio by William J. Bernstein
Compounding is a fundamental concept in investing that is often overlooked or misunderstood by many investors. It is the process by which the returns earned on an investment are reinvested to generate additional returns in subsequent periods. This can have a significant impact on the overall growth of an investment over time. The power of compounding lies in its ability to accelerate the growth of an investment exponentially. By reinvesting returns, an investor is able to earn returns on both the initial investment and the returns generated in previous periods. This can result in a snowball effect, where the investment grows larger and larger with each passing period. For example, suppose an investor invests $1,000 in an investment that generates a 10% return each year. In the first year, the investor would earn $100 in returns. Instead of withdrawing this $100, if the investor reinvests it, they would earn $110 ($1,000 initial investment + $100 return) in the second year. This process continues, with each year's returns compounding on the previous years' returns. Over time, compounding can have a dramatic impact on the returns generated by an investment. Even small differences in the rate of return can lead to significant disparities in the final value of an investment over the long term. This is why it is important for investors to understand the power of compounding and to take advantage of it in their investment strategies. By harnessing the power of compounding, investors can potentially achieve higher returns and build wealth more quickly than they would by simply relying on their initial investment. This is why it is often said that time is the investor's best friend when it comes to compounding. The longer an investor stays invested, the greater the impact of compounding on their returns.
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