Insights · Letter No. 3 · Fundamentals
The quiet power of compounding
Compounding is slow at first and dramatic later. Understanding its shape is the single most useful idea in personal finance.
Compounding means earning returns on your past returns. In the first years the effect is almost invisible. Later it dominates everything else. The shape of that curve explains why time in the market matters more than almost any decision you make inside it.
A simple example
Invest $10,000 at a steady 7% a year and leave it alone. After 10 years it is about $19,700. After 20 years, about $38,700. After 30 years, about $76,100. The last ten years add more than the first twenty combined, even though nothing about the investment changed. Only time did.
Illustration only: a hypothetical 7% annual return, compounded yearly, with no taxes or fees. Real returns vary and can be negative.
The rule of 72
Divide 72 by an annual growth rate to estimate how many years it takes to double. At 6%, about 12 years. At 9%, about 8. At 3%, about 24. It is a rough guide, but it makes the stakes of a percentage point vivid.
Starting early beats starting big
Consider two savers earning a hypothetical 7%. One invests $300 a month from age 25 to 35, then stops. The other starts at 35 and invests $300 a month until 65, thirty years in all. At 65, the early saver has about $421,000 and the late saver about $366,000. The early saver put in $36,000; the late saver put in $108,000.
Compounding works against you, too
The same math runs in reverse on high-interest debt. A credit card balance at 22% doubles in a little over three years if nothing is paid. That is why paying down expensive debt is often the best "investment" available. See our letter on paying off debt.
Three ways to let it work
- Start now, even small. Time is the variable you cannot buy back.
- Keep costs low. Fees and taxes are subtracted every year and compound against you.
- Don't interrupt it. Selling in a panic, or cashing out early, resets the clock.
Try your own numbers in the compound growth calculator.
This letter is general education, not a recommendation to buy or sell any security. Consider your own situation, and a licensed professional, before making financial decisions.