Compound growth
Compounding is when your investment returns start generating their own returns, on top of your original money, growth building on growth. The effect is small and unremarkable in the early years, but accelerates dramatically over long stretches of time, which is why starting early matters so much more than most people expect.
A worked example
Invest $5,000 once and never add another cent, earning 8% a year. After 10 years it's about $10,800. After 20 years, about $23,300, more than double the 10-year figure, even though only twice the time passed. After 30 years, about $50,300, because by then you're earning 8% not just on your original $5,000, but on decades of accumulated growth too.
Key takeaways
- Compounding means your money earns returns, and then those returns start earning returns too.
- The effect looks slow at first and accelerates significantly the longer money stays invested.
- Starting 10 years earlier can matter more than contributing significantly more money later.
Common mistakes
- Underestimating how much starting a few years earlier actually matters.
- Withdrawing invested money early, interrupting the compounding process.
- Expecting compounding to feel dramatic in the first year or two, it doesn't, the real effect shows up much later.
Test yourself
1. What does "compounding" mean in investing?
- Losing money faster over time
- Your returns start generating their own returns, on top of the original amount
- A type of stock
- A government tax
Answer: Your returns start generating their own returns, on top of the original amount. Compounding is growth building on top of previous growth, not just on the original invested amount.
2. When does the compounding effect become most dramatic?
- In the first year only
- Over long stretches of time, especially later years
- It never really matters
- Only in months with a 31st day
Answer: Over long stretches of time, especially later years. Compounding accelerates the longer money stays invested, the effect is subtle early and much larger later.
3. Why does starting to invest early matter so much?
- It doesn't matter at all
- More time lets compounding work for longer, which can outweigh contributing more money later
- Early investors get special discounts
- Markets are safer for early investors
Answer: More time lets compounding work for longer, which can outweigh contributing more money later. Extra years of compounding time can be worth more than larger contributions made later, because growth builds on growth for longer.
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Sources and further reading
- Investor.gov (U.S. SEC): Introduction to Investing
- Investor.gov: Glossary of investing terms
- FINRA: Investing basics for individuals