How compounding works

It’s easier to understand how compounding — and investing in general — works if you consider some actual numbers.

Let’s say you start out with $2,000 in your pocket. Sure, that plasma TV seriously tempts you, but instead, you do the responsible thing and invest. And then something miraculous happens: Your original investment, called your principal, makes money. In one year, let’s say it increases in value by 8% — known as an investment return — and is now worth $2,160, or $2,166 if it compounded monthly.

The next year, imagine your investment increases by the same percentage again, but now, since you started with more, what you have is not $2,332 — twice the $166 you got the first year — but $2,346. What happened? Your interest compounded. And at this rate, assuming you don’t take any money out along the way, your original $2,000 investment would be worth $9,854 in 20 years — for no effort on your part.

And if you think that’s good, say you add $2,000 to your investment each year — just a little over $38 a week or $167 a month — money set aside after everyday expenses. If you did that and all the other conditions stayed the same, your original investment would be worth $108,876 after 20 years — while that plasma TV would be history. That’s the beauty of compounding.

Of course, investing returns aren’t guaranteed, so it’s possible that your return could be less than an average 8%, and you could even lose money if the investment choices you made didn’t turn out as well as you expected. But the advantage of investing while you’re young is that you have lots of time to accumulate what you need.