Compounding is one of the most powerful concepts in finance, yet it’s often misunderstood or overlooked. Simply put, compounding is the process by which your investments grow exponentially over time because you earn returns on both your original investment and on the returns generated previously. Albert Einstein famously called compounding the “eighth wonder of the world,” and for good reason—its effects can be staggering over the long term.

1. The Magic of Time: Small Gains, Big Results

The true power of compounding comes from time. The longer you allow your money to grow, the more dramatic the effects. Consider this: if you invest £10,000 at a 7% annual return, it will take about 10 years to double your money. But over 30 years, that same £1,000 will grow to almost £76,000—and over 50 years, it becomes nearly £300,000. 

In his book The Little Book of Common-Sense Investing, John C. Bogle stresses that "time is your friend; impulse is your enemy." The earlier you start investing, the more time you give compounding to work its magic, making a small initial investment much larger over the years.

2. Compound Interest vs. Simple Interest

Let’s clarify the difference between simple interest and compound interest. With simple interest, you earn returns only on your initial investment. For example, if you invest £10,000 with a 5% simple interest rate for 10 years, you’ll earn £5,000 in interest, for a total of £15,000.

However, with compound interest, you earn interest on your initial investment and on the interest you’ve already accumulated. With the same £10,000 investment at 5% compounded annually, after 10 years, you’ll have £16,288. Over a longer period, this difference becomes significantly larger.

3. Real-Life Examples of Compounding

Perhaps the most famous example of compounding comes from Warren Buffett, whose incredible wealth—estimated at over $115 billion—is largely due to compounding. As highlighted in Morgan Housel’s The Psychology of Money, Buffett’s fortune is not just a result of smart investing but also due to time. Buffett began investing at the age of 10, and more than 99% of his wealth came after his 50th birthday. The secret? He let compounding work for him over the course of many decades.

Another compelling example comes from the S&P 500 Index, which has delivered an average annual return of around 10% over the last 90 years. If you had invested £10,000 in the S&P 500 in 1990, that amount would now be worth over £190,000—thanks to the compounding effect over 30 years.

4. The Patience Problem: Why We Struggle With Compounding

One of the biggest reasons people fail to benefit from compounding is that it requires patience. The early stages of compounding often feel slow, and the rewards seem small. As Charlie Munger, Buffett’s longtime business partner, puts it, “The first rule of compounding is to never interrupt it unnecessarily.”

People are often tempted to withdraw their investments or chase quick gains, which disrupts the compounding process. But those who stick with it and allow their money to grow over decades will see the most impressive results.

A study from Dalbar reveals that the average investor significantly underperforms the market, with many buying and selling too frequently, failing to harness the power of compounding. Over the past 20 years, the average investor earned just 7.7%, compared to the 10.7% return of the broader market. This gap is largely due to investors interrupting the compounding process by moving in and out of the market based on short-term fluctuations.

5. The Role of Reinvestment

To truly unlock the power of compounding, it’s essential to reinvest your earnings. Whether it’s dividends from stocks or interest from savings, reinvesting instead of spending these returns increases the amount you’re compounding, leading to faster growth.

For example, dividend-paying stocks in the S&P 500 have contributed approximately 40% of the index’s total returns over the last 90 years. By reinvesting dividends, investors can grow their wealth much faster than if they simply collect their dividend payments without reinvesting.

6. Compounding in Debt: The Double-Edged Sword

While compounding can be your greatest ally in building wealth, it can also work against you when it comes to debt. Compounding interest on loans or credit card debt can quickly accumulate if payments are missed or if only minimum payments are made.

Consider a £10,000 credit card debt with a 20% interest rate. If you only make the minimum payments, that debt can balloon to £25,000 within 10 years due to compound interest working in reverse. Just as compounding can exponentially grow your wealth, it can also rapidly increase your liabilities if not managed carefully.

Conclusion: Start Early, Stay Consistent

The power of compounding shows that wealth is built not just by making smart investments, but by giving those investments time to grow. The earlier you start, the better, and the more disciplined you are about leaving your money to compound, the greater your results will be.

Whether it’s through consistent investments in a stock market index fund, reinvesting dividends, or patiently holding onto long-term assets, compounding works best when left uninterrupted. Remember, as Einstein once said, “He who understands it, earns it; he who doesn’t, pays it.”

References:  

• Housel, Morgan. The Psychology of Money: Timeless Lessons on Wealth, Greed, and Happiness. Harriman House, 2020.  

• Bogle, John C. The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns. Wiley, 2007.  

• Dalbar, Inc. “Quantitative Analysis of Investor Behavior 2020.”  

• Munger, Charlie. “The Munger Rule of Compounding,” speech at University of Southern California Business School, 1994.