The “Magic” of Compounding, Explained

By Ellevest Team

Compounding gets thrown around a lot when people talk about money and personal finance. And often, the people using the word just assume that whomever they’re talking to will know what it means.

Except that not everyone knows what it means — because let’s face it, high school didn’t do much to help most of us learn about real-life money management.

The Magic of Compounding, Explained

So … what is compounding?

Compounding is what happens when you take a number and increase it over and over again by a percentage (think “10% annual growth”). That’s opposed to increasing it by a fixed number (think “add 10 each year”).

To demonstrate how the mathemagical phenomenon of compounding works, let’s use a delicious example: lattes. (ICYMI, we’re big on lattes here at Ellevest.)

OK, say you drink 100 lattes a month. That would be a highly concerning caffeine level, but we’re trying to make the math easy here. So one day, your fairy frothmother shows up and tells you that she is granting your wish: That milky (or soy milky or oat milky) goodness will increase by 10% every month.

OK, so 10% of 100 lattes is 10 more lattes, right? Right. So here’s how you might assume that would look:

Month 0 (when you start): 100☕
Month 1: 100 + 10 = 110☕
Month 2: 100 + 10 + 10 = 120☕
Month 3: 100 + 10 + 10 + 10 = 130☕
Month 4: 100 + 10 + 10 + 10 + 10 = 140☕
Month 5: 100 + 10 + 10 + 10 + 10 + 10 = 150☕
Total extra lattes after 5 months: 50☕

But that’s not actually how compounding works. You don’t just get an additional 10% of your original 100 lattes every month. Instead, you get an additional 10% of your total number of lattes every month (rounded below because who wants only part of a latte?):

Month 0 (when you start): 100☕
Month 1: 100 + (100 x 10%) = 110☕
Month 2: 110 + (110 x 10%) = 121☕
Month 3: 121 + (121 x 10%) = 133☕
Month 4: 133 + (133 x 10%) = 146☕
Month 5: 146 + (146 x 10%) = 161☕
Total extra lattes after 5 months: 61☕

Boom. When the number is compounded, you end up with more coffee in the end. That’s the magic. (Very high-energy magic.)

Got it. What does this have to do with my money?

There are two main ways compounding comes into play when it comes to money: compound interest and compound returns.

Compound interest

As you might expect, this comes into play when you’re earning interest on your money. For example, if a savings account pays the current national average of about 1%, then your money will increase by 1% every year. (Like the coffee, but not as delicious.)

But compounding can work against you, too — like when you owe compound interest on debt. For example, if the annual interest rate on your credit card is the current national average of about 18%, then the amount of debt you owe will increase by 18% every year. (Definitely not as delicious.)

Compound returns

Compound returns usually come up when we talk about investing. In this case, you aren’t earning interest, which is a promised, steady amount — you’re potentially earning investing returns, which are definitely not guaranteed and definitely not steady. But they can be super powerful.

Here’s an explainer on how investments can make money. But to make that long-ish story short, when the value of the individual investments you own, like stocks and bonds, goes up (or down), that makes the balance in your investment account go up (or down). As long as you leave the difference invested, then your returns have the opportunity to compound over time.

So if the markets were to go up for a big chunk of the time you had money invested, compounding would work in your favor. And yes, that goes the other way too if the markets decline — that’s why we say that investing comes with risk. BUT. The longer you let compounding work its mathemagic, the more likely you are to have overall positive returns (at least, that’s been the case historically). Case in point: Stocks are typically the riskiest part of an investment portfolio, and they’ve gone up in about 75% of years since 1928 — in fact, the stock market’s average annual return has been about 9.8%.

That’s why investing can be more useful than simply saving as you work toward your money goals, build wealth, and take advantage of the market’s potential for growth.

So getting started ASAP is a big deal — the higher your account’s balance and the longer your money’s invested, the more opportunity it has to compound over time.

Every day you wait is a day you miss out on the opportunity to start compounding. We’re talking about real money here — by our calculation, it could be about $100 a day. That’s like giving yourself a pay cut of over $17 an hour. Or nearly $3,000 a month.* Yup.

There’s no time to waste.


Source Ellevest. To calculate “about $100,” we compared the wealth outcomes for a woman who begins investing at age 30 with one who began investing at age 40 after having saved in a bank for 10 years. Both women begin with an $85,000 salary at age 30 and all salaries were projected using a women-specific salary curve from Morningstar Investment Management LLC, a registered investment adviser and subsidiary of Morningstar, Inc., which includes the impact of inflation. We assume savings of 20% of salary each year. The bank savings account assumes an average annual yield of 1% and a 22% tax rate on the interest earned, with no account fees. The investment account assumes an investment with Ellevest using a low-cost diversified portfolio of ETFs beginning at 91% equity and gradually becoming more conservative during the last 20 years, settling at 56% equity by the end of the 50-year horizon. These results are determined using a Monte Carlo simulation—a forward-looking, computer-based calculation in which we run portfolios and savings rates through hundreds of different economic scenarios to determine a range of possible outcomes. The results reflect a 70% likelihood of achieving the amounts shown or better, and include the impact of Ellevest fees, inflation, and taxes on interest, dividends, and realized capital gains. We divided the calculated cost of waiting 10 years to invest, $341,181, by 3,650 (the number of days in 10 years). The resulting cost per day is about $93.47. Dividing that result by 24 hours results in $3.89 per hour.

To translate that result into pay rates, we assume a 30-day month, resulting in a cost per month of $2,843. We then assume the average number of hours worked per month is 160 (40 hours per week multiplied by 4 weeks), resulting in an hourly cost of $17.77.

The results presented are hypothetical, and do not reflect actual investment results, the performance of any Ellevest product, or any account of any Ellevest client, which may vary materially from the results portrayed for various reasons.

© 2020–2021 Ellevest, Inc. All Rights Reserved.

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The practice of investing a fixed dollar amount on a regular basis does not ensure a profit and does not protect against loss in declining markets. It involves continuous investing regardless of fluctuating price levels. Investors should consider their ability to continue investing through periods of fluctuating market conditions.

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Diversification does not ensure a profit or protect against a loss in a declining market. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.

Investing entails risk, including the possible loss of principal, and there is no assurance that the investment will provide positive performance over any period of time.

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Ellevest Team

The Ellevest team is working to help women reach their financial and professional goals.