How much difference does compounding make over time?

To illustrate the maths: if you invest a sum at a given annual return, the difference between compound and simple interest grows dramatically over time. A typical mathematical illustration shows that reinvesting returns can produce several times the result compared to simple interest after 30 years. The exact outcome depends entirely on actual returns, which cannot be predicted. Past performance is not a guarantee of future results.

Why are low fees so important?

A fee of 1.5 percent instead of 0.5 percent may seem marginal. But 1 percent per year multiplied by 30 years and the compounding effect means a large portion of your capital disappears. Every percent of fees is one percent not compounding.

Does compounding only apply to savings?

No. The principle applies equally to a company's reinvestment of its profits. That is what to look for: companies that can reinvest at high returns for a long time. That is compounding at the company level.

How long a time horizon is needed?

The effect always exists, but becomes truly powerful after 15 to 20 years. That is an argument for holding companies with the intention of keeping them for a long time. What time horizon suits you as a saver depends on your personal situation.

Glossary

Compounding

The effect of returns generating further returns. Given enough time, it is the most powerful phenomenon in investing.

What it is

Time's most important side effect

Compounding means that the return on capital in turn generates return. If you invest 100 and earn 8 percent per year, after one year you have 108. The next year you earn 8 percent on 108, not on 100. The difference sounds small but is enormous over time. The maths is simple. The effect is profound.

Time is the most important factor: Compounding requires patience. Most of Buffett's wealth was accumulated after the age of 60, even though he invested professionally from his teens.
Fees are the enemy: A fund fee of 1.5 percent per year may seem small. But over 30 years it can cost you a third of your capital in lost compounding.
Reinvestment is the key: The effect only occurs if returns are reinvested. An accumulating fund does this automatically. A distributing fund requires you to reinvest dividends actively.

In practice

Companies that compound on their own

Companies that can reinvest their earnings at high returns for a long time are the complement to compounding at portfolio level. Companies with that quality create enormous value per share without the investor having to do anything. That is the core of growing out of a valuation. The company compounds on its own.

“The maths is simple. The patience is hard. But it is the patience that turns the maths into money.”

Amos Fonder

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Common questions about compounding

Related concepts

Glossary

Normalised earnings

What a company can earn under normal conditions, stripped of temporary factors. The foundation for assessing sustainable profitability and fair value.

Active Fund Management

A management strategy where the portfolio manager actively selects stocks, unlike a passive index fund that mechanically tracks a benchmark. The goal is to generate returns above the index.

Net asset value

The value of a company's underlying assets minus its liabilities. Primarily used when analysing investment companies and asset-heavy businesses.

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