Compounding refers to the rate at which money grows if you automatically reinvest all the profit you make in the same investment. To help you understand the concept of compounding, we will use a simple example of a bank account that pays interest. A bank can pay you two kinds of interest: simple interest or compound interest.

Simple Interest

Suppose you have $1,000 in the bank that pays 10% simple interest per year for 10 years. Each year, you will earn $100 interest on your $1,000 investment (in the bank account) as calculated below:

Yearly Interest = Yearly Interest Percentage x Deposit Amount

Yearly Interest = 10% x $1,000 = .1 x $1,000 = $100

The yearly simple interest for the 10-year period is shown below:

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As you can see, the total amount of simple interest earned in the 10-year period is $1,000. We calculated this amount by multiplying the yearly interest of 10% by the initial amount you deposited in your account (the principal balance of $1,000) and adding up the resulting products for the 10-year period. Since you get back your initial principal balance of $1,000, you will receive a total of $2,000 at the end of the 10-year period. Remember that this simple interest method shown in the example above assumes that your yearly profit of $100 is not reinvested into the account.

Compound Interest

If the bank tells you that you will earn 10% yearly compound interest on your deposit (instead of 10% simple interest), you will make more on your investment than in the simple interest case. Once again, on a yearly basis, you will be earning 10% profit on your principal. But the difference in this case is that your yearly profit (i.e. your yearly interest) will be reinvested each year into the bank account, and not taken out, as was the case with the simple interest calculation above. Here is how your money will stack up each year with compound interest:

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With yearly compounding, the interest earned in one year is reinvested into the bank account in the next year. You can tell that this is the case because the Principal Balance column above is increasing so interest is applied to a bigger and bigger principal balance each year. With the yearly compound interest method, the principal balance increases from $1,000 in the first year to $2,357.90 in the tenth year. With the simple interest method, the principal balance stays at $1,000 for all ten years. At the end of the tenth year for the yearly compound interest example, the total interest earned is $1,593.70 as opposed to $1,000 with simple interest-a difference of $593.70.
Compounding can be done yearly (as is the case in our example), monthly, daily, or in any other time interval. Once again, we will spare you the agony of the mathematics here but we can show you how it is done on www.teenvestor.com if you are curious.

Why Compounding Is Your Friend

In our prior two examples, yearly compound interest was higher than simple interest by $593.70. This may seem like a small number, but remember that we assumed you deposited only $1,000 for a 10-year period. As the initial deposit balance increases, the difference between compounding interest and simple interest gets bigger and bigger. As the time the money stays in the account (or in the investment) increases, this difference also gets bigger and bigger.

The reason we are telling you all of this is because compounding also has a big effect on the money you put into stocks, bonds, mutual funds, and other investments. We will now apply this concept to the return on investment in stocks.

Recall we mentioned in another section of this website that over the past 72 years, the average return on investment for stocks was about 11% per year. This means that on the average, someone investing in stocks (and reinvesting all her dividends as well) could have made 11% profit each year over a long, long period of time. Because of the compounding effect of investments, a long-term investor can double her money every seven or eight years if we assume an 11% annual profit. Imagine the profit if the investment balance were bigger. This multiplication effect of invested money is one of the reasons it is wise to invest for the long run. We explain more about compounding in another section.