Compounding

Earning returns on your past returns, not only on your original money.

Example

$1,000 growing at 8% a year is worth about $1,080 after one year and about $2,159 after ten years - the second decade of growth builds on the first, not just on the initial $1,000.

Important

Compounding needs time more than it needs a high rate - starting ten years earlier at a modest return usually beats starting later at a better one.

Related terms

  • CAGR (compound annual growth rate) — The single steady annual growth rate that would take a starting value to an ending value over a given number of years.
  • Reinvestment — Using an investment's income or gains to buy more of the same investment, rather than taking them as cash.
  • Time value of money — The idea that money available now is worth more than the same amount later, because it can be invested in the meantime.

Lessons that explain it

  • The schedule, and the part of the return nobody prints on it — A bond's cash flows are written down in advance. What those cash flows finally compound to is not, and that gap is where the quoted yield quietly makes an assumption on your behalf. (11 min)
  • Interest, and a rate somebody else can change — The whole return is a rate applied to a balance. What makes it unlike every other asset class is that the rate is set by the institution, can be changed at will, and you have agreed to that in advance. (10 min)
  • The fund manufactures nothing: pass-through, minus costs — A fund's return is the weighted return of its holdings less what it charges. Knowing that changes what you are actually forecasting when you forecast a fund. (11 min)
  • Three sources: employer money, tax saved, and compounding left alone — Returns inside a retirement account come from the investments, plus two things outside the market: employer contributions and the tax that is not taken each year. (11 min)
  • CAGR: the smoothed rate, and the path it deletes — Compound annual growth rate is the straight line drawn between two points. Two investments with identical CAGRs can be completely different experiences to live through. (11 min)
  • How compounding works — Compounding is earning returns on your returns, not just your original money - and time, more than the rate itself, is what makes it powerful. (12 min)

All 578 terms in the Investing glossary