TERM OF THE DAY

Compounding

Compounding is the process where the value of an investment increases because the earnings on an investment, both capital gains and interest, earn interest as time passes. This exponential growth occurs because the total growth of an investment along with its principal earn money in the next period. This differs from linear growth, where only the principal earns interest each period.

BREAKING DOWN ‘Compounding’

This phenomenon, which is a direct realization of the time value of money, is also known as compound interest. For example, suppose a $10,000 investment in Company X earns 20% the first year. The total investment is then worth $12,000. Next, assume that in the second year, the investment earns another 20%. In year two, the total balance of $12,000 would earn 20%, ending with a value of $14,400 instead of $14,000. The extra $400 of growth is due to the $2,000 earning of year one also growing at 20% in year two, along with the principal.