Compounding interest and investment returns: The incremental approach to building wealth

Open full sized image

With compounding, money + time = more money.

© baona—iStock/Getty Images

Compounding is a powerful way to build wealth. It’s when the earnings from your investments get added to your original investment pile (i.e., reinvested), and those earnings then build upon themselves.

Stories of investors making huge returns on penny stocks or cryptocurrencies get plenty of attention. But that’s not how most wealth is created. Instead, wealth creation is typically the get-rich-slowly kind, powered by compounding.

Interest on your interest. Returns on your investment returns. No wonder it’s been called the eighth wonder of the world.

How does compounding work? Suppose you start with $1,000 in your retirement account. You might invest it in something simple, such as a fund that tracks the benchmark S&P 500 index. You can probably find one of those in your 401(k) plan, and they’re great for beginning investors because of their low cost.

Suppose the returns over three years were 5%, 20%, and 8%, respectively. If each year, those returns were based off the initial $1,000 (i.e., not compounded), the returns would be:

The three-year total, not compounded, would be the initial $1,000, plus $50, $200, and $80, which equals $1,330. Now let’s watch the growth of that $1,000 with the magic of compounding.

Notice something? The first year was simple. Your initial $1,000 gained 5% along with the market, or $50. But in Year 2, your 20% gains weren’t based on the original $1,000 you invested. Instead, they grew from $1,050, reflecting your initial investment plus the $50 you gained in year one. In Year 3, the compounding had an even more pronounced effect.

And that extra bump you get from compounding builds on itself. Slowly at first, but as the years go by, the effect of compounding will continue to accelerate.

Granted, this is an oversimplification. And of course, stock market returns can vary greatly. In some years, stocks even lose money. But, according to data from S&P Global, U.S. stocks have returned about 9.2% over the long term.

Compounding doesn’t apply exclusively to stocks. Suppose you buy a bond that pays a fixed 4% annual interest (or a 4% “coupon,” in bond lingo). You invest $1,000 and earn $40 the first year. Assuming you can reinvest the extra $40 at 4%, the next year you’ll see a gain of $41.60, because it’s based on $1,040. That’s the power of compound interest.

Enjoying the fruits of compounding takes patience. But if you can keep your hands off your retirement fund—and keep adding to it—compounding can be surprisingly powerful.

Compounding is especially effective if you start early and add fresh funds each month. If you’re investing with a 401(k), some of this extra cash can come from your company’s matching contributions (if it provides them). Just remember, an early start can make a huge difference once you reach retirement age, because compounded returns have had more time to build on themselves. The longer you stay invested, the larger compounded returns can become.

Let’s follow two imaginary investors, Amelia and Ben. Amelia begins with $1,000 at age 25, and she invests $200 a month for 40 years until she retires at age 65. Her annual return averages 10%.

Ben waits longer to start investing. He has a lot of bills (college debt is rough) and it takes him a while to find a steady job right after college. Ben also starts with an initial investment of $1,000, but he begins at age 35, not 25. He also enjoys 10% annual returns, but has 10 fewer years to enjoy the benefits of compounding before he retires, also at age 65.

How did things turn out for our two hypothetical investors?

Harnessing the power of compounded returns—and getting an early start—is a solid strategy to steer toward your long-term financial goals. It may not be as flashy as making a quick buck in crypto or getting lucky with a penny stock, but building wealth typically takes time, patience, and compounded returns.