What does the concept of compound interest involve?

The concept of compound interest involves earning interest on both the initial principal and the accumulated interest from previous periods. This means that in each compounding period, the interest that is calculated is added to the principal, and future interest calculations are performed on this new total.

This approach to interest is powerful because it allows investments to grow at an accelerating rate over time, leading to greater returns compared to simple interest, which is calculated only on the principal amount. The process of compounding can significantly increase the amount of money earned or owed, especially over longer periods or with higher interest rates.

In contrast, receiving a fixed return on investments does not account for the growth that comes from compounding, as it typically implies that the return does not change over time. Investing only in risk-free bonds limits the investment's potential returns, which can be achieved through compound interest in other more volatile investment options. Lastly, calculating interest based solely on the original amount ignores the crucial principle of compounding, which is essential for maximizing growth in an investment over time.