What is Investing? Interest, Inflation and Compounding

The idea behind investing is that money is put to use in such a way that it is likely to turn into more money. This could happen because someone is willing to pay interest to use the money or because the value of whatever security the money was used to buy increases during the period of ownership. Destinations for invested money include savings accounts, stocks, bonds, mutual funds and numerous other investment options.

It is important to note that because money can be invested, the value of a given amount of money changes over time.

The longer that a given amount of money is under your control, the longer you have to invest it and make more money from it. For this reason, it is almost always preferable to have money sooner rather than later. The name given to this concept is the "time value of money"; that is, the idea that a dollar now is worth more than a dollar in the future, because a dollar now can accrue value through interest or other appreciation until the time at which the dollar in the future would be received.

At the same time, there is a penalty associated with not investing the money that you already have. Because prices tend to rise over time, the value of money gradually decreases. This effect is called inflation. Money that is not invested or that is accruing value at a slower rate than the rate of inflation is becoming worth less and less as time passes. Therefore, investing is not only an opportunity to make more money, but it is the only way to protect the money that you already have.

Another spectacular benefit associated with many investments is compounding. Money that is earning interest grows at a constant rate, paying the same amount of interest at the end of each time period. However, if that interest is added to the principal that began earning money originally, there is more money earning interest. In this way, interest causes money to increase in value exponentially over time. As more and more money earns interest, more and more interest is earned. This scenario is constantly playing out in bank accounts, CDs, and any other investment that offers compound interest. The more frequently the interest compounds, the bigger the payoff because, on average, more money is earning interest at any given time.

At this point, it is important to distinguish between investing and gambling. Earning interest and taking advantage of compounding may not produce the immediate jackpot that comes with winning the lottery, but the risk of ending up with nothing is often far worse than waiting for a safe investment to pay off. Pouring a great deal of money into one stock is very similar to gambling. It could pay off, but if it doesn't the potential losses are great. Safe and diverse investments may slow the pace of returns, but they also prevent the bottom from falling out and leaving you with nothing.

By InvestorGuide Staff

Copyrighted 2020. Content published with author's permission.

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