Compound interest is the accrual of interest on both the principal and interest for the previous period.
In contrast to the simple interest, which is accrued each time on the same (initial) amount, with the use of compound interest there is a regular recalculation: to the initial amount is added income for a certain period and then the reward is accrued already on the increased amount of investments.
Simply put, income generates new income and grows like a snowball. This is called "interest on interest" or capitalization. It can be daily, monthly, quarterly, or annually, depending on the terms of the contract.
In other words, when you receive dividends on stocks or interest on bonds and instead of withdrawing them from your account, you invest them again. The next return you get is not only on the original investment, but also on the reinvested profits. This is compound interest. Simple interest is when you only get a return on what you originally invested.
Compound interest works with dividends on stocks and coupons on bonds.
It can also be charged on loans. Over time, it also increases the amount owed. In other words, compound interest is more favorable for deposits and investments than simple interest, and vice versa for loans.
Advantages and disadvantages of Compound Interest
The main advantage of compound interest is that your money starts to multiply faster. You sort of build up the speed of your enrichment, constantly feeding your investment portfolio.
There are two disadvantages. First, you don't get money in your hands, you don't spend it on yourself. And you can not indulge yourself in any benefits.
For example, your friends take out loans from banks and live in euro-renovated apartments, buy expensive cars. And you want to achieve financial freedom, constantly investing and living in a small old apartment, using a used car. Not all people can psychologically endure this.
The second disadvantage. If you make risky investments and don't protect them, you can lose your money. Or you may lose your money for several years. For example, because of the crisis.
How to protect Compound Interest investments
The ways of investment protection in compound interest investing are similar to protection of ordinary investments. First of all, proper diversification is a key. The general principles are as follows: invest in different financial instruments (stocks, bonds), in companies in different economic sectors, in companies in different countries.
You can even use a compounding interest of some investments for other investments. For example, when you get high interest in stocks, you can invest this money to buy bonds.
Other than diversification and rebalancing, there are no options to protect against risk.
How compound interest and capitalization are related. In banking, it's exactly the same thing. That is, "capitalization," "compound interest," and "interest on interest" are names for the same type of calculation.
But in economics, capitalization is a broader concept. It doesn't always mean the accrual of interest according to some scheme. It can be something else altogether, such as the valuation of a company's assets.