How compounding works
With simple growth, $1,000 earning 7% gains $70 every year. With compound growth, year one earns $70, but year two earns 7% on $1,070, which is $74.90. The extra amount is small at first and becomes large with time.
The formula is: future value = starting amount × (1 + rate)^years. The exponent is why time is so powerful.
A worked example
$10,000 growing at an average 7% a year becomes roughly $19,700 after 10 years, $38,700 after 20 years and $76,100 after 30 years. The last ten years add more than the first twenty combined. These figures assume a steady rate; real markets vary year to year, so actual results will differ.
The rule of 72
Divide 72 by the annual rate to estimate how many years it takes money to double. At 6%, about 12 years. At 9%, about 8 years. It is a shortcut, not an exact calculation.
What slows compounding
- Fees: a 1% annual fee compounds too, and can take a large share of long-term growth.
- Taxes on gains and dividends each year.
- Withdrawals, which remove the base that future returns grow on.
- Large losses: a 50% drop needs a 100% gain to recover.
- Inflation, which reduces what the final balance can buy.
Key takeaways
- Compounding means returns earning returns.
- Time is the biggest driver; later years contribute the most.
- Fees, taxes, withdrawals and deep losses all compound against you.