How growth compounds

A return on the return

Put $1,000 somewhere that grows 7% a year. (The rate is illustrative; real returns go up and down.) After one year you have $1,070. The $70 is your return.

Now leave all $1,070 where it is. In the second year, 7% is earned on $1,070, not on the $1,000 you started with. That is $74.90, and you end the year with $1,144.90. In the third year, 7% of $1,144.90 is $80.14, and you have $1,225.04.

Each year’s growth is a little larger than the year before, because the base it grows from keeps getting bigger. Earning a return on your earlier returns is called compounding — or compound interest, when the return is interest.

Small at first, then large

In the first years compounding looks like nothing: $4.90 here, $10 there. It shows over the long run.

A handy shortcut is the rule of 72: divide 72 by the yearly rate to find, roughly, how many years money takes to double. At 7%, 72 ÷ 7 ≈ 10 years. The $1,000 above is worth about $1,967 after 10 years, $3,870 after 20 and $7,612 after 30 — close to doubling each decade.

Change the rate and the years, and watch the gap between the two lines. Notice that most of it opens up at the end.

Reinvesting is what makes it work

Compounding needs the return to stay invested. If a share pays you a dividend and you spend it, that money stops growing. If you use it to buy more of the investment, it starts earning returns of its own.

That is the difference between the two results in the example: the same 7%, but in one case it is taken out every year and in the other it is left to work. Many funds and brokers can reinvest dividends automatically. With a bank deposit, reinvesting simply means leaving the interest in the account.

Why starting early matters

Because the largest growth comes at the end, the number of years matters more than almost anything else. At 7%, ten extra years at the start add roughly one more doubling at the end.

This is not a reason to feel late. Whatever age you start at, the years ahead of you are the ones compounding works with. It is a reason not to wait for a perfect moment that may never come.

Regular contributions

For most people the money does not arrive as one large sum. It comes from a salary, a little at a time. Each contribution starts its own small compounding story: the first $100 has the longest to grow, the latest one the shortest.

That is why a steady habit matters as much as the rate. Adding money regularly keeps the base growing, and the base is what each year’s return is calculated on. The next lesson, Time in the market, looks at investing regularly while prices go up and down.

Compounding against you

The same arithmetic applies to anything that grows by a percentage each year. An unpaid credit-card balance compounds: interest is charged on earlier interest. Fees compound too. A fund that charges 1% a year — its expense ratio — takes 1% of a growing balance every year, and what it takes no longer compounds for you. The Funds path shows how much that adds up to over decades.

In short

Compounding is growth on growth: each year’s return is earned on everything already there, including earlier returns. It needs time and reinvesting to work, and it shows mostly in the later years — which is why starting earlier and adding regularly matter. It works the same way on debt and fees, in the other direction.