What is Compounding?
Murakkab foiz (compounding)
In short
Returns earning returns: growth is added to the base and next year grows from a larger amount. The longer the time, the bigger the effect.
Compounding means returns themselves earn returns. Each year's growth is added to the base, and the next year grows from a larger amount. As a result, capital grows not in a straight line but at an accelerating pace.
Formula
- Final amount = Starting amount × (1 + annual return)^years
With simple interest, the return is calculated on the starting amount only, every year.
Three factors
- Time — the most powerful factor. The effect is felt most in the final years, so starting early matters.
- Rate of return — even a 2–3% a year difference becomes huge over decades.
- Reinvestment — when dividends and gains are reinvested instead of withdrawn, the effect works in full. That is why total return matters more than price gain alone.
For a quick estimate, the rule of 72: 72 ÷ annual rate = years for capital to double.
The flip side
Compounding works on losses too. After a 50% loss you need a 100% gain to get back. High fees and costs also compound into large sums over the years. That is why avoiding big drawdowns and keeping costs low are decisive for long-term results.
At 60: ~$91,800 versus ~$38,000. The first investor put in only $4,800 more but ended with 2.4 times as much — ten extra years of compounding did that.
$12,000 put in, worth ~$18,300. Most of the gap appears in the last years — compounding speeds up with time. 8% is an example, not a promise.
Example
$10,000 at an average 8% a year (an assumption, not a guarantee):
- 10 years: $10,000 × 1.08^10 ≈ $21,589
- 20 years: $10,000 × 1.08^20 ≈ $46,610
- 30 years: $10,000 × 1.08^30 ≈ $100,627
With simple interest ($800 a year only), 30 years would give $10,000 + $800 × 30 = $34,000. The difference is over $66,000, and most of it builds up in the last 10 years. By the rule of 72, at 8% capital doubles roughly every 72 ÷ 8 = 9 years. Check your own numbers with the compound interest calculator or the time-to-goal calculator.
Mistakes and tips
Start early: starting 10 years earlier with a small amount often beats starting later with a large one.
Reinvest dividends and gains — money you withdraw no longer compounds.
Avoid large losses: a deep drawdown sets compounding back by years.
Be realistic about the assumed return — markets don't rise the same amount every year, and some years are negative.
Calculate it
Frequently asked questions
- What is the difference between compound and simple interest?
- With simple interest, the return is calculated only on the starting amount each year. With compounding, past returns are added to the base and earn returns themselves.
- What is the rule of 72?
- A quick way to estimate how many years it takes capital to double: divide 72 by the annual rate. For example, at 6% it takes about 12 years.
Learn it in the Academy
This term is covered with hands-on examples and a quiz in these lessons of the interactive course.
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