If you earn 10% a year, what is your total return after ten years? Most people answer 100%. That answer is wrong, because it ignores compounding. The correct answer is 159%.
The mechanism is simple. The first year’s gain takes part in the second year’s growth, and the second year’s gain produces gains of its own. The longer the horizon, the more dramatic the effect.
Einstein is said to have called compound interest the eighth wonder of the world: those who understand it earn it, and those who do not pay it. So how do ordinary investors put it to work? Two things matter.
1. A satisfactory rate of return
Small differences in return become enormous differences over time. Take $10,000:
| Annual return | Value after 20 years |
|---|---|
| 8% | $47,000 |
| 15% | $164,000 |
The rate of return is roughly twice as high, and the outcome is two and a half times as large.
2. A long enough time horizon
Time matters just as much. Keep the same $10,000 compounding at 10%:
- 40 years → $450,000
- 41 years → $500,000
Holding on for one more year earns an extra $50,000.
In the short run, investing is about the rate of return. In the long run, it is about time. Time is compounding’s best friend.