Unit-I

What Is Compounding?

Compounding is the process in which an asset’s earnings, from either capital gains or interest,
are reinvested to generate additional earnings over time. This growth, calculated using
exponential functions, occurs because the investment will generate earnings from both its initial
principal and the accumulated earnings from preceding periods.

Compounding, therefore, differs from linear growth, where only the principal earns interest
each period.

 Compounding is the process whereby interest is credited to an existing principal amount

as well as to interest already paid.
 Compounding thus can be construed as interest on interest—the effect of which is to
magnify returns to interest over time, the so-called “miracle of compounding.”
 When banks or financial institutions credit compound interest, they will use a
compounding period such as annual, monthly, or daily.
 Compounding may occur on investment in which savings grow more quickly or on debt
where the amount owed may grow even if payments are being made.
 Compounding naturally occurs in savings accounts; some investments that yield
dividends may also benefit from compounding.

Understanding Compounding

Compounding typically refers to the increasing value of an asset due to the interest earned on
both a principal and accumulated interest. This phenomenon, which is a direct realization of
the time value of money (TMV) concept, is also known as compound interest.

Compounding is crucial in finance, and the gains attributable to its effects are the motivation
behind many investing strategies. For example, many corporations offer dividend
reinvestment plans (DRIPs) that allow investors to reinvest their cash dividends to purchase
additional shares of stock. Reinvesting in more of these dividend-paying shares compounds
investor returns because the increased number of shares will consistently increase future income
from dividend payouts, assuming steady dividends.

Investing in dividend growth stocks on top of reinvesting dividends adds another layer of
compounding to this strategy that some investors refer to as double compounding. In this
case, not only are dividends being reinvested to buy more shares, but these dividend growth
stocks are also increasing their per-share payouts.

Compounding is a powerful investing concept that involves earning returns on both your original
investment and on returns you received previously. For compounding to work, you need to
reinvest your returns back into your account.

Formula for Compound Interest

The formula for the future value (FV) of a current asset relies on the concept of
compound interest. It takes into account the present value of an asset, the annual interest rate,
the frequency of compounding (or the number of compounding periods) per year, and the total
number of years. The generalized formula for compound interest is:

FV =PVX 1+ ( ni )
where:

FV=Future value

PV=Present value i=Annual interest rate

n=Number of compounding periods per time period

t=The time period

This formula assumes that no additional changes outside of interest are made to the original
principal balance.

Increased Compounding Periods

The effects of compounding strengthen as the frequency of compounding increases. Assume a

one-year time period. The more compounding periods throughout this one year, the higher the
future value of the investment, so naturally, two compounding periods per year are better than
one, and four compounding periods per year are better than two.

To illustrate this effect, consider the following example given the above formula. Assume that
an investment of $1 million earns 20% per year. The resulting future value, based on a varying
number of compounding periods, is:

 Annual compounding (n = 1): FV = $1,000,000 × [1 + (20%/1)] (1 x 1) = $1,200,000

 Semi-annual compounding (n = 2): FV = $1,000,000 × [1 + (20%/2)] (2 x 1) =
$1,210,000
 Quarterly compounding (n = 4): FV = $1,000,000 × [1 + (20%/4)] (4 x 1) = $1,215,506
 Monthly compounding (n = 12): FV = $1,000,000 × [1 + (20%/12)] (12 x 1) = $1,219,391
 Weekly compounding (n = 52): FV = $1,000,000 × [1 + (20%/52)] (52 x 1) = $1,220,934
 Daily compounding (n = 365): FV = $1,000,000 × [1 + (20%/365)] (365 x 1) = $1,221,336

As evident, the future value increases by a smaller margin even as the number of compounding
periods per year increases significantly. The frequency of compounding over a set length of
time has a limited effect on an investment’s growth. This limit, based on calculus, is known
as continuous compounding and can be calculated using the formula:

FV=P×ert
where: e=Irrational number 2.7183, r=Interest rate, t=Time

In the above example, the future value with continuous compounding equals: FV = $1,000,000
× 2.7183 (0.2 x 1) = $1,221,403.

 Investing and trading both involve buying financial assets, such as mutual
funds, ETFs, and individual stocks, with the goal of growing your money.
 The difference is in the timeline. Investing typically involves hanging onto an
asset for years, if not decades. Trading on the other hand could mean buying
and selling many types of assets within the span of a day, week, or month.

Unit-II
Trading and Investing

Trading and investing might sound like interchangeable words for trying to grow your money in
the stock market. But they mean different things—and come with their own set of risks and
potential benefits. Knowing them can help you determine which one is best for your money and
overall financial strategy.

What is investing?
Investing is buying an asset, like an individual stock, mutual fund, or exchange-traded fund
(ETF), in hopes of increasing your money over time. Because most people invest for long-term
goals, like buying a house, paying for college, or saving for retirement, they tend to hold these
assets for a long time—meaning years, if not decades.

What is trading?
Trading is buying and selling financial assets, like individual stocks, ETFs (a basket of many
stocks and other assets), bonds, commodities, and more, in hopes of making a short-term profit.
Traders could be buying and selling investments multiple times a day, week, or month. Though
technically you "make a trade" anytime you buy or sell an investment, most people associate
trading with an active investing strategy.
Differences between Trading and Investing
 There are several differences between trading and investing, but the most popular
differences are the investment approach and the time involved.

 Investment Approach between Investing and Trading

The critical difference between investing and trading is the type of approach involved
in both methods. In investing, the investor uses the fundamental analysis of the
company, and in trading, it involves technical analysis.

Fundamental analysis involves the company's financial analysis, previous financial

records of the company, analysis of the industry on which the company is based, and
the overall performance of the industry based on the macroeconomic situations in the
country and the results.

Technical analysis is everyday financial trends such as the company's performance in

numbers based on the uptrends and downtrends in the market every day. It requires
the traders to study the company closely and every day as it makes financial decisions
and reflects in the charts and numbers in the stock market. This data helps the traders
to make significant predictions of the changes and involves studying trends in
volume, price, and moving averages.

Traders need to act dynamically and buy or sell based on the current trends while
investors study the company closely, invest in it and hold it for a longer period to earn
profit with lesser risk.

 Time-Based and Risk-Based differences between Investing and Trading

There is a difference in time involved in both the market-based money investments.
Investing involves studying the company closely and holding it for a longer period
with the expectation that it will return profits in the long haul; this type of investment
involves lesser risk and may incur not huge profits but are relatively safe to the
market trends. A classic example of "investing" is mutual funds and involves lesser
risk and lesser profit. Other examples are bonds or baskets of stocks for long holding
 positions. The time frame can range years together and is less dynamic. The trend in
the market that lasts for a shorter period does not make any difference to the investors.

Trading studies the companies closely with everyday trends to predict the future
change on which they could earn better profits. This is a short-term investment and
can involve buying and selling within a single day, weeks, or months based on the
market situations. It is a high risk-reward ratio as the market is volatile, and one
wrong decision can incur huge losses. A classic example of trading is the basis of the
stock market, where the trader buys a certain number of stocks when the prices are
low and sells them when the prices are high to generate huge profits. This time
approach not only allows the traders to make quick transactions but also earn more
compared to the long-term investors.

Final words

The major differences between investing and trading are approaches, risk, and time
involved. It is okay to do both, and it depends on the risk-taking ability and patience of the
person to choose between either of these or both of these. Investing is long-term and
involves lesser risk, while trading is short-term and involves high risk. Both earn profits,
but traders frequently earn more profit compared to investors when they make the right
decisions, and the market is performing accordingly.

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