Compounding
This article explains compounding in practical terms and why it is one of the most important forces in long-term investing. The focus is on how small differences in return and time lead to very large differences in outcomes.
Compounding in simple terms
Compounding happens when:
- you earn a return on your capital, and
- future returns are earned on both the original capital and past returns
The key feature is that growth builds on itself.
What matters most is not short-term performance, but how long capital is allowed to compound and at what rate.
Why compounding matters more than it first appears
In the early years, compounding looks slow. Most of the visible growth happens later.
This often leads investors to underestimate its impact and overestimate the importance of short-term decisions.
Example 1: same capital, different time horizons
Assume:
- Initial capital: £100,000
- Annual return: 6%
- Returns are reinvested
Growth over time
| Year | Value (£) |
|---|---|
| 0 | 100,000 |
| 5 | 133,800 |
| 10 | 179,100 |
| 15 | 239,700 |
| 20 | 320,700 |
What this shows
- In the first 10 years, capital increases by about £79,000
- In the next 10 years, it increases by about £142,000
- Most of the growth happens later, not earlier
Time is doing more work than effort.
Example 2: small return differences, large outcome differences
Now compare three different returns over the same period.
Assumptions
- Initial capital: £100,000
- Time horizon: 20 years
Compounded outcomes
| Annual return | Value after 20 years (£) |
|---|---|
| 3% | 180,600 |
| 6% | 320,700 |
| 9% | 560,400 |
Practical interpretation
- 6% does not give twice the result of 3% — it gives almost double the money
- 9% produces more than three times the outcome of 3%
Small improvements in return, sustained over time, dominate almost everything else.
Compounding and reinvestment
Compounding only works if returns are not removed.
If income is spent rather than reinvested:
- growth slows dramatically
- capital stagnates
- long-term outcomes weaken
This is why early reinvestment is so powerful, even if income feels modest at first.
Example 3: reinvesting versus withdrawing income
Assume:
- Initial capital: £200,000
- Annual return: 6%
- Time horizon: 15 years
Case A: reinvest all returns
| Year | Capital (£) |
|---|---|
| 0 | 200,000 |
| 15 | 479,400 |
Case B: withdraw returns annually
| Outcome | Amount (£) |
|---|---|
| Capital after 15 years | 200,000 |
| Total income received | 180,000 |
| Total value | 380,000 |
What this shows
Reinvestment produces:
- £99,000 more value
- without adding new capital
- purely through compounding
The cost of early withdrawals is much higher than it appears.
Compounding in real estate
In property, compounding appears through:
- reinvested rental income
- rent increases over time
- gradual debt reduction
- reinvestment into additional properties
Even modest yields can compound meaningfully if income is reinvested consistently.
Why compounding rewards patience
Compounding favours investors who:
- start early
- avoid unnecessary disruption
- minimise large mistakes
- allow time to do the work
It penalises constant trading, impatience, and short-term thinking.
Common mistakes that weaken compounding
- chasing short-term gains
- frequently resetting investments
- withdrawing income too early
- focusing on headline returns instead of sustainability
These behaviours interrupt the compounding process.
Key point to remember
Compounding is not about clever decisions every year.
It is about one good decision, followed by enough time and discipline to let growth build on itself. Small advantages, applied consistently, become overwhelming given enough time.