Long-term investing: How compounding growth works

Called by some the eighth wonder of the world, compounding growth (also known as compounding interest or compounding returns) is the interest your investment earns, as well as the interest your returns earn over time. This means your money can potentially earn more money over time when your returns start gaining interest too. Sound interest-ing yet? 

Compounding growth takes time and a patient investor, and we’re big advocates of long-term investing here at Hatch. When you understand the impact that compounding growth can have,  the benefits of long-term investing can speak louder than the day-to-day market headlines.

So how does compounding growth work? And what can it mean for you?  

How compounding growth works in investing

Say you invested $1,000, based on an average return of 10% a year, which is the historical average percentage return for the US share markets since the 1950s. This is how the growth of that $1,000 could have compounded over time:

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With the same 10% annual return, the value of the returns grow more each year because not only are you earning interest on the initial investment, but you’re also earning interest on the returns gained. It’s kind of like a snowball rolling down a hill picking up more snow on its journey. 

This is where time can have a huge impact and the numbers on that long-term horizon get exciting!. If someone had made a one-off investment of $1,000 in 1970, and received an average 10% annual return, by the year 2000, 30 years later, it could have reached $17,449.90. And if you’d had the opportunity to invest that $1,000 65 years ago with a 10% annual return, it could now have grown to $1,000,356.28 without ever adding to that initial investment. Like magic, hey? You can try experimenting with compounding growth yourself using Sorted’s calculator.

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In the short term, it's hard to predict whether, or how much, the share markets may increase or decrease in value - share prices go up and down regularly. This may mean that leaving your investments as long as possible gives the best chance of compounding returns to do their work, and for your investment to ride out the bumps in the market.

Take a look for yourself! Google the share price for large, well-established companies and look at the share price over a long period of time. The share price goes up and down over the short and even medium term, but in the long run, over decades, the graph line typically points up for mature companies.

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Compounding growth works - even with some bad years

If you’re wanting to reap the rewards of compounding growth, it’s a long-term game. As we said earlier, you shouldn’t be investing money that you may need in the immediate or near future. This is because yes, there may be some bad years when you see a negative return. However, compounding growth can still work even with some bad years if you’re in it for the long run. 

Using that same $1,000 investment, let's run the numbers again based on the average returns of the S&P 500 over the past ten years:

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In 2020, there was a -18.01% return and just over $700 was lost - ouch! But does it really matter over the long term? The investment has tripled in just 10 years and was still worth $2,229.16 more than was invested. 

And remember, even if your investment dips below what you paid for it, you never actually make or lose money until you sell your shares.

Saving vs. Investing

Compounding growth works the same way in an interest-bearing savings account as it does with investing. So when should you use a savings account, and when should you invest? There’s a major difference between the two and that’s the consistency of returns. Knowing the difference between the two could be the difference between reaching your goals or saving yourself poor.

Savings Account

Compounding growth works on your savings the same as your investments, however, when you put your money in a savings account, the interest gained is generally lower than the historical average percentage return for the US share markets. For example, if you had $1,000 in a term deposit at a 3% interest rate, the total amount would have grown by 3%. However, sometimes even the best interest rates on offer can be lower than inflation! This means even with compounding growth, your money may still have been decreasing in value over time when compared with inflation and the cost of living. Savings account interest rates do tend to fluctuate but they are generally more stable than the share markets. Savings accounts play a very important role in reaching your financial goals. They are great for any money that you may need immediately or in the near future, for example, your emergency savings, or if you’re saving for a specific thing such as a house deposit. 

Investing

Historically, the share markets have increased in value by an average of about 10% yearly, but they don't always increase yearly. An investment may grow by 30% in one year, 2%, in the next year and -10% the year after. In fact, based on this example of rises and falls, you’d still see an average return of 7%. Investing for the long term means you’re better placed to ride out these bumps in the market - the longer you leave your investment, the longer you have to bounce back from any falls, and the higher the average return you can potentially gain. However, if you are going to need your money in the near future, you’re at more risk of losing some of your investment in a shorter period of time.

Read more in our guide to savings vs. investing.

Compounding growth summary

It’s with noting that while the share market has gone up and down every year, the average historical return has been 10%. Bear in mind that individual company shares might have short (or even long) periods of higher growth, or they could even end up worth nothing at all! So always do your research and think about things like diversification, which is spreading your money across a range of investments.

It’s also important to remember that while bank accounts generally offer a fairly predictable small return in the short term, that predictability (and inflation) could be costing you in the long run. The effect of compounding growth in the share markets can take much longer, and the best way to let compounding growth work its magic is by giving it time.

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