Financiers aren't that different from chefs. They have to decide how much of what to put where, find the best method of mixing it all together, and keep customers coming back. They are artisans of their crafts.
In finance, “discrete compounding” is a recipe that has multiple variations. Discrete compounding is a method of calculating compound interest at certain points in time. Compounding interest, as opposed to simple interest, is where the interested is calculated, then added to the principal before the next round of interest is calculated. Because the new interest at each calculation round is added to the principal, a loan with compounding interest will rise much faster than a loan with simple interest (think: exponentially rather than linearly).
The “discrete” in “discrete compounding” just means this snowball process happens at certain intervals of time, say weekly, monthly, or possibly annually. This is different from continuous compounding, which, as the creative name would have you assume, is compounding continuously (usually daily, but it could be more often), and not at set intervals of time.
Let’s think about your bank account and how it calculates interest that it gives you. You might think having an account that has more instances of compounding would mean much more money for you, but it doesn’t. The more often the money sitting in your bank is compounded, yes, the more money you will get technically, but by a lot less than you’d think (like...a lot less).
For instance, one round of compounding (i.e. an account with annual discrete compounding) on $1,000 at 2% would get you $1,020. If your account was continuously compounding (daily) for a year on that same $1,000, then you’d have $1,020.20. Yep, compounding that $1,000 365 times in a year only gets you 20 cents more than compounding once in a year. Still, because compounding interest grows at an increasing rate, that can add up over time, bit by bit. By bit by bit.
By bit.
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Finance allah shmoop What is calm Pounding value or compounding
interest Ah the power of compounding it makes tree's stronger
pollution More feral and the rich Well richer How so
Well let's start with compounds kissing cousin with six toes
Arithmetic calm pounding Right So the first was really geometric
compounding Now we're talking about arithmetic compounding If you invest
a thousand bucks in a ten year bond that pay
six percent a year in interest the dough comes back
to you in a pattern that looks like this Like
every six months they pay thirty bucks and it's sixty
dollars a year Got it nice You get the total
of sixteen hundred bucks back from your investment And the
cash that came back to you you know came in
small parts all along the way until you got about
two thirds of it or sixty percent at the end
right If you just spent that money and collected your
thousand bucks at the end That's it Okay So that's
arithmetic compounding the money comes to you You don't reinvest
it Ding ding ding that's the key here and you
just go buy burgers Okay So now let's look at
what six percent compound id looks like over the same
ten year period Wealth at the end of your one
it's a thousand sixty bucks and no we're only going
to compound it annually We probably should do the semi
annually but we confuse you even more is we won't
do that but then you essentially re invest that money
and you get another six percent compounded on that thousand
sixty instead of six percent compounded against the original thousand
so by the end of your two you'll have a
thousand one hundred twenty three sixty and by the end
of your ten you'll have one thousand seven hundred ninety
dollars and eighty five cents So why do you make
so much more money when you compound interest versus getting
thirty bucks twice a year like you would in this
bond example going by and burgers with it You don't
wanna do that well essentially what's happening is that you're
delaying your gratification of getting that sweet sweet cash or
getting liquid Whatever you wanna call it by reinvesting your
gains year after year after year So do you have
that sort of self control Do you need the cash
Yeah that's The question If you for example have trouble
making it home from your local pizza spot with the
pie intact well and compound interest Keeping the discipline to
not spend the money today and wait for the happiness
tomorrow Well when that may not be for you Sorry