Compounding
What is compounding?
Now that we understand how investing differs from saving, this section introduces one of the key ideas behind long-term investing: compounding.
Compounding describes how returns are continually added to an investment and become part of the total amount – a bit like rolling a snowball down a hill, the snowball gets bigger because it’s gathering a similar amount of snow, just on a slightly larger ball. The same concept is true with investing. The returns themselves can start to earn returns on their own without you putting in any more yourself. Future returns are then calculated on this larger total, not only on the original amount invested.
As returns continue to be added, the total value gets larger and any further interest is calculated off a larger amount without you having added any more cash. This means growth is based on a changing total rather than a fixed starting point.
The effect may not be noticeable in the early stages, but over time it can become more significant, particularly when returns remain invested. This means the longer returns stay invested, the more opportunity there is for compounding to build, and starting earlier allows more time for this process to take place.
How reinvesting works
To understand compounding, it helps to look at what happens when returns stay invested instead of being withdrawn.
Imagine you invest £100. If the investment grows by 5% in one year, it would increase to £105. If that £5 return is withdrawn, the amount remaining invested stays at £100.
If instead the £5 return remains invested, the total becomes £105. If the investment then grows by 5% again the following year, 5% is calculated on £105 rather than £100. This would result in £110.25 instead of £110.
This is a simplified example to show how compounding works. Investment returns aren’t guaranteed and can go up or down.
This step-by-step process continues: an initial investment, a return generated, that return added to the total, and future returns calculated on the larger amount, building in the same way as the snowball example above.
The same principle also applies in negative years. If the value falls, the reduction is calculated on the current total. Returns, whether positive or negative, affect the amount on which future returns are based.
Why time makes a difference
Compounding becomes more noticeable over longer periods of time.
In the early years, the effect of compounding can appear gradual. When the starting amount is relatively small, the difference created by returns earning returns may not seem dramatic.
However, each period builds on the total created by the previous one. A return is added to the investment, and the next return is calculated on that larger amount. When this process repeats over many years, there are more opportunities for returns to build on earlier returns.
More time means more years in which returns can be added and then generate further returns. Each year of growth or decline affects the amount used to calculate the following year’s return.
It is also important to remember that markets fluctuate from year to year. Some years may see growth, while others may see declines. Compounding reflects how returns accumulate over time, but it does not remove the ups and downs of investing.
Compounding over decades
Over decades, the cumulative effect can look very different from the early years. When money remains invested for long periods, the repeated cycle of returns building on previous returns has more time to operate.
This does not mean growth happens in a straight line. Markets can rise and fall, and some periods may see declines rather than increases.
Each period of change, whether positive or negative, affects the amount used to calculate future returns.
Because of this, long-term investing often requires patience and an understanding that short-term fluctuations are part of the process. Spreading investments across different types of assets can help manage the ups and downs that occur over time. This is something we will explore in the next chapter.