Compound Growth: How Your Money Makes Money (And More Money!)

Imagine you’re planting a seed. That seed is your initial investment. Now, imagine that seed grows into a plant that not only produces fruit, but those fruits contain even more seeds that can also be planted and grow. That, in essence, is the power of compound growth in investing.

In the simplest terms, compound growth is earning returns not just on your initial investment, but also on the returns you’ve already earned. It’s often described as “interest on interest,” or “returns on returns.” Think of it like a snowball rolling down a hill. At first, it’s small and gathers snow slowly. But as it rolls, it gets bigger and bigger, accumulating more snow at an increasingly rapid pace. Compound growth works the same way with your investments.

Let’s illustrate this with a straightforward example. Suppose you invest $100. And let’s say this investment earns a 10% return each year.

• Year 1: Your $100 investment earns 10%, which is $10. So, at the end of Year 1, you have $110 ($100 original investment + $10 earnings).
• Year 2: Now, here’s where the magic of compounding begins. In Year 2, you don’t just earn 10% on your initial $100. You earn 10% on the entire $110 you now have. 10% of $110 is $11. So, at the end of Year 2, you have $121 ($110 from last year + $11 earnings).
• Year 3: Again, the growth accelerates. You earn 10% on the $121 you now have. 10% of $121 is $12.10. So, at the end of Year 3, you have $133.10 ($121 from last year + $12.10 earnings).

Notice how the amount you earned each year increased? In Year 1, you earned $10. In Year 2, you earned $11. In Year 3, you earned $12.10. This is compound growth in action. Your earnings are generating their own earnings, leading to exponential growth over time.

To truly benefit from compound growth in investing, two key ingredients are essential:

1. Time: Time is the most powerful ally of compound growth. The longer your money stays invested and keeps compounding, the more significant the effect becomes. In the early years, the growth might seem slow and steady, but over decades, the snowball effect becomes incredibly potent. This is why starting to invest early, even with small amounts, is so crucial.

2. Reinvestment: For compound growth to work, you generally need to reinvest your earnings. In our example, we assumed you left the earnings in your investment account each year. If you took out the $10 earned in Year 1 and spent it, then in Year 2 you would only earn 10% on the original $100, missing out on the compounding effect. In most investment scenarios, like stocks or mutual funds, reinvestment is often automatic – any dividends or profits are typically reinvested back into the investment, allowing the compounding to continue.

It’s important to distinguish compound growth from simple interest. Simple interest is calculated only on the principal amount, the initial investment. In our example, if it was simple interest, you would earn $10 each year (10% of $100), regardless of how much your investment grew. After three years with simple interest, you would have $130 ($100 + $10 + $10 + $10). While still good, it’s significantly less than the $133.10 you achieved with compound growth. Over longer periods, the difference becomes even more dramatic.

Compound growth is a fundamental principle in investing and is the engine that drives long-term wealth creation. By understanding and harnessing its power, you can significantly increase your financial future. It’s not about getting rich quick, but about patiently letting your money work for you, growing steadily and exponentially over time, like that snowball rolling down the hill, becoming larger and more impactful with each passing moment. The earlier you start, and the longer you let it work, the more remarkable the results will be.