The power of compounding

Compounding returns are a key principle in wealth creation and understanding how it works is the first step toward reaching your investment goals. Put simply, compounding means earning returns on the returns you earn over time. In the short term, its effects can be relatively minor. But longer term, compounding has the potential to increase your returns exponentially. Consider this example.

Let’s say you start with an initial investment of $10,000. And on that you earn 10% p.a. every year after fees and tax. After your first year you’d have $11,000 (your initial $10,000 + 10% returns = $1,000).

By the end of year two, your investment is now $12,100 ($11,000 + 10% = $12,100). The thing to note is that compared to the previous year your returns have increased by an extra $100. That’s because you earned 10% on your invested sum, and also 10% on the returns from the previous year. Now that extra $100 might not seem like much. But using this example, after ten years your initial investment would have grown to $25,937 and the returns earned that year would have risen to $2,358. That’s the power of compounding.

The example below shows the effect of compounding over 40 years and is for illustrative purposes only.