What Is Compound Interest?
Compound interest is the process of earningreturns not just on your original investment, but also on the interest orincome that investment generates over time. It is interest on interest, or inthe case of shares, dividends on reinvested dividends.
Unlike simple interest, which is onlycalculated on the principal amount, compound interest grows your balanceexponentially by reinvesting earnings at regular intervals. The longer yourmoney remains invested and the more frequently it compounds, the faster it cangrow.
This is why starting early matters. Time isnot just a factor; it is the engine that drives compounding.
Time: The Most Valuable Investment Asset
Consider this example. Investor A beginsinvesting $300 per month at age 25 and stops at 35. Investor B starts investing$300 per month at age 35 and continues until 65. Assuming a 7% average annualreturn, Investor A will likely end up with more money—even though theycontributed for fewer years.
Why? Because the returns earned in theearly years had decades to compound.
This demonstrates one of the most importantprinciples in wealth building: it’s not just how much you invest, but howlong it has to grow. Starting early gives you more options, moreflexibility, and more financial freedom later in life.
How Compound Interest Works in Practice
The formula for compound interest is:
A = P(1 + r/n)ⁿᵗ
Where:
- A is the final amount
- P is the principal investment
- r is the annual interest rate (as a decimal)
- n is the number of times interest is compounded per year
- t is the number of years
Let’s break this down with a simpleexample:
If you invest $10,000 at an 8% annualreturn, compounded yearly for 20 years:
- With simple interest, your final amount is $26,000
- With compound interest, your final amount is over $46,000
That’s an additional $20,000 just byletting the returns reinvest. The compounding effect becomes more dramatic thelonger you leave the money untouched.
Compounding and the Share Market
Compound interest is not limited to savingsaccounts. In fact, its greatest power is seen in long-term investing.
When investing in ASX shares, compoundingoccurs when you reinvest dividends or realised capital gains into more shares.This expands your portfolio base, meaning the next round of dividends iscalculated on a larger holding, generating even more income.
This compounding cycle repeats over time,especially if you automate dividend reinvestment and maintain a buy-and-holdstrategy. Some of the strongest long-term performers on the ASX—likeCommonwealth Bank, CSL, or Wesfarmers—have delivered significant wealth toinvestors who simply reinvested dividends over time.
Frequency and Consistency Matter
Another important factor in compounding isfrequency. The more often your returns are reinvested, the greater the impact.
For example, an investment that compoundsmonthly will grow faster than one that compounds annually, even if the rate ofreturn is the same. In the context of shares, dividend reinvestment plans(DRPs) allow for automatic reinvestment, effectively increasing the frequencyof compounding.
Consistency also counts. Making regularcontributions to your savings or investment plan, even in small amounts, candramatically improve your long-term results. Over time, these contributionssnowball into meaningful wealth—particularly if you resist the urge to withdrawearly.
