Compounding

Updated Dec 31, 2022

Definition of Compounding

Compounding is the process of generating earnings on an asset’s reinvested earnings. That means it is the accumulation of earnings from an initial investment over time. Or in other words, it describes the interest you earn on your interest that you earned on your interest (and so on). This process is also known as the “rule of 72,” which states that an investment will double in value in approximately 72 divided by the rate of return.

Example

To illustrate this, let’s look at a simple example. Imagine you invest USD 10,000 in a savings account with an annual interest rate of 5%. After one year, you will have earned USD 500 in interest. That means your total balance is now USD 10,500. Now, if you reinvest these USD 500 in the same account, you will earn an additional USD 25 in interest the following year. That means your total balance is now USD 11,025. If you do that for another year, your total balance will be USD 11,576.25, and so on. This process of reinvesting earnings is called compounding.

Why Compounding Matters

Compounding is an incredibly powerful tool for growing wealth over time. That’s because it allows you to earn money on your returns. The more you reinvest, the more you earn. That’s why it’s often referred to as the “miracle of compounding.”

Compounding is also a great way to save for retirement. That’s because it allows you to take advantage of the power of compounding over a long period of time. For example, if you start investing USD 500 per month in a retirement account with an 8% annual return, you will have saved over USD 1.5 million in 40 years. That’s why it’s important to start investing early.