What is compounding?
Compounding – or a compound return – is where you earn a return on the growth of your investments. Instead of withdrawing your gains, you reinvest them, allowing your money to grow even more over time. That’s because the total amount of money you’ll have invested will also be increasing.
Compounding can apply to both your investment gains and the interest you earn on your savings.
How does compounding work?
Let’s illustrate with an example. Both of the people in this scenario invest a lump sum of £1,000 in year one, with no additional contributions. For simplicity, we assume a consistent 5% annual return, though actual investment returns may vary.
Person A withdraws their gains each year, while person B lets their gains compound. The figures shown are the annual return that each person earns in that year.
| Year | Person A | Person B |
| 1 | £50 | £50 |
| 2 | £50 | £52.50 |
| 3 | £50 | £55.13 |
| 4 | £50 | £57.88 |
| 5 | £50 | £60.76 |
At the end of year five, person A would have an end pot of £1,250 – but person B would have an end pot of £1276.27. So just by leaving their money alone, person B has earned £26.27 more in the same amount of time as person A.
Please note when investing you may get back less than you invest, and returns are not guaranteed.
Maximising compound returns: the power of time
Time is your greatest ally in compoundingThe return you earn on top of your investment gains by reinvesting your profits instead of withdrawing them.. The more time your money has to compound, the more significant the growth. That’s why it’s really important to start investing as soon as you’re able – like once you’ve got your emergency fund sorted.
The longer you invest for, the longer you’ll be exposed to the performance of the market – which makes it more likely that you’ll ride out any downturns, and you’ll also benefit from the market’s average rate of return.
The Rule of 72 is a helpful way to calculate the approximate time it takes to double your money at a given rate without adding a penny to your original investment. To estimate the time required to double an original investment, divide 72 by the expected annual return.
For example, at a 6% annual return, your money would take 12 years to double (72 divided by 6), according to the Rule of 72.
You’re just one lesson away from completing the Moneybox Investing Academy! In our final lesson, we’ll look at pound cost averaging and how regular investing can help you capture the average return of the market.
All investing should be long term (minimum five years) and historic performance isn’t a guarantee of future returns. The value of your investments can go up and down, and you may get back less than you invest. We don’t provide investing advice, and investors should make their own investment decisions or contact an independent adviser.