What are compounding returns?

Compounding is earning returns on the growth your investment makes. Longer term, it has the potential to increase the value of your investment significantly. Consider the example below:

Compounding in action

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 (10% return on initial $10,000 = $1,000).

By the end of year two, your investment is now worth $12,100 (10% return on $11,000 = $1,100). 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 and is for illustrative purposes only. Neither the growth rate nor the cash value is guaranteed.

The power of compounding

A $10,000 initial investment, with a 10% p.a. return every year, and the returns are not reinvested, over a 40-year time horizon.

A $10,000 initial investment, with a 10% p.a. return every year, and the returns are reinvested, over a 40-year time horizon.

A $10,000 initial investment, plus a $50 deposit every month, with a 10% p.a. return every year, and the returns are reinvested, over a 40-year time horizon.