What is compounding growth?

Think about how hard you work for that pay rise. And when you get it, while it’s tempting to upgrade your car, take that extended vacay, or shop for a new wardrobe, there may be other options that could put your money to work. We're talking about how interest is calculated, called compounding growth, and how it may increase over time without you having to lift a finger.

Called by some the eighth wonder of the world, compounding growth is when money can make more money, potentially increasing over time. Sounds too good to be true? CNBC’s Mad Money host Jim Cranmer is passionate about helping people to understand how share markets work, and he’s said ‘The magic of compounding works best the younger you are, because that means you have more time for your money to grow’.

How compounding growth works in investing

Say you invested $1,000, based on an average compounding return of 10% a year - the historical average percentage return for the US share markets since the 1950s  - this 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 an investment would have grown more each year. This is because the returns on the initial investment were also earning returns. Try experimenting with compounding growth using Sorted’s calculator or this one on interest.co.nz.

It’s kind of like a snowball rolling down a hill picking up more snow on its journey. Historically, receiving a 10% return may have meant that an initial $1,000 deposit could have doubled every seven+ years or so. Yep, if someone had made a one-off $1,000 investment in 1970, by the year 2000, 30 years later, it could have reached $17,449.90. And by 2020 at 10% compounding growth over 50 years, it could have reached $117,390. Without even adding to that first deposit. Like magic, huh?

And if you’d had the opportunity to invest that $1,000 65 years ago with a 10% compounding growth rate, it could now have grown to $1,000,356.28.

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I get compounding interest on my savings, why invest?

Compounding growth works the same way on interest on investments as it does with savings, with two major differences:

One: Consistency of returns

With investing, your money doesn’t grow by a fixed, consistent percentage. Historically, the share markets have increased in value by an average of about 10% a year, but they don't increase every year. Some years, an investment may grow by 30%, other years it may be 2% and others it may drop to -10%. What does that mean for compounding growth? Well, potentially not much really; you just take a leaf from Carnmer’s books when he said, ‘Thanks to the magic of compounding, the earlier in your life you start investing in the market, the bigger your long-term gains can be’. 

Two: How big the snowball could potentially grow

Compounding growth works on your savings the same as your investments. So, for example, if you had $1,000 in a term deposit at a 1% interest rate, the total amount would have grown by 1% a year. However, that 1% rate is historically often lower than inflation, which 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. While savings can play an important role in helping you reach your financial goals, a savings account may not be the only way to put your money to work and reap any potential benefits of compounding growth.

Compounding growth works even with some bad years

Because investing is a long-term game, compounding growth can still work even if a company or ETF’s shares don’t increase in value every year. How? Using that same $1,000 investment, lets run the numbers again with five years of changing percentage returns:

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In year 4, your investment had a –4.4% return. Ouch, you lost over $60!

But is it really painful across the long term? Your investment may have dropped in value, but it was still worth $322.39 more than you invested. That’s because the value of your shares had grown enough that a negative return still left you with more than you started with.

Even if your investment dips below what you paid for it, you never actually make or lose money until you sell your shares. So generally a good course of action is to dollar cost average your investments and be prepared for market volatility along the way.

How does compounding growth work over time?

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. However, since 1928, the share markets have increased in value 75% of the time. This may mean that leaving your investments as long as possible gives the best chance of compounding returns to do their work.

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Compounding growth summary

It’s important to keep in mind that the average historical return for the share markets as a whole has been 10%. Bear in mind that individual company shares might have short (or even long) periods of higher growth, or they might 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 like Exchange-Traded Funds (ETFs). 

It’s also important to remember that while bank accounts generally offer a fairly predictable small return, the effect of compounding growth in the share markets can take much longer. But predictability (and inflation) may be costing you when it comes to compounding returns. The best way to let compounding growth do its work is time!