Compounding

Loading the player...

What is 'Compounding'

Compounding is the ability of an asset to generate earnings, which are then reinvested in order to generate their own earnings. In other words, compounding refers to generating earnings from previous earnings.

Also known as "compound interest".

BREAKING DOWN 'Compounding'

Suppose you invest $10,000 into Cory's Tequila Company (ticker: CTC). The first year, the shares rises 20%. Your investment is now worth $12,000. Based on good performance, you hold the stock. In Year 2, the shares appreciate another 20%. Therefore, your $12,000 grows to $14,400. Rather than your shares appreciating an additional $2,000 (20%) like they did in the first year, they appreciate an additional $400, because the $2,000 you gained in the first year grew by 20% too. If you extrapolate the process out, the numbers can start to get very big as your previous earnings start to provide returns. In fact, $10,000 invested at 20% annually for 25 years would grow to nearly $1,000,000 (and that's without adding any money to the investment)!

The power of compounding was said to be deemed the eighth wonder of the world - or so the story goes - by Albert Einstein.

RELATED TERMS
  1. Compound Interest

    Compound Interest is interest calculated on the initial principal ...
  2. Continuous Compounding

    The process of earning interest on top of interest. The interest ...
  3. Discrete Compounding

    Discrete compounding refers to the method by which interest is ...
  4. Compound Return

    The rate of return, usually expressed as a percentage, that represents ...
  5. Biotech Compound

    A chemical entity that forms the starting point in the drug development ...
  6. Effective Annual Interest Rate

    Effective Annual Interest Rate is an investment's annual rate ...
Related Articles
  1. Professionals

    The Effect Of Compounding

    Learn all about this important function that Einstein thought was the greatest mathematical discovery ever.
  2. Bonds & Fixed Income

    Accelerating Returns With Continuous Compounding

    Investopedia explains the natural log and exponential functions used to calculate this value.
  3. Investing

    How does Compound Interest Work?

    A quick way to understand the impact of compound interest is to ask yourself if you’d rather receive $100,000 a day for a month, or start with a penny on day one and double it every day for those ...
  4. Personal Finance

    Crafty Compounding

    It is easier to become a millionaire now that at any time before. While you won' be buying islands, it is still a goal worth shooting for.
  5. Savings

    How Interest Rates Work on Savings Accounts

    Here's what you need to know to grow your rainy-day fund.
  6. Investing Basics

    Understanding Compound Interest

    Compound interest is often called one of the most powerful concepts in finance. Find out what it is and how it can work for you.
  7. Investing Basics

    Learn Simple And Compound Interest

    Interest is defined as the cost of borrowing money, and depending on how it is calculated, can be classified as simple interest or compound interest.
  8. Options & Futures

    Investing 101: The Concept Of Compounding

    Albert Einstein called compound interest "the greatest mathematical discovery of all time". We think this is true partly because, unlike the trigonometry or calculus you studied back in high ...
  9. Mutual Funds & ETFs

    5 Best Ways to Earn Interest

    Learn how to use tools to increase your interest earnings. Use compounding interest and breakpoints to increase your interest income.
  10. Investing Basics

    APR and APY: Why Your Bank Hopes You Can't Tell The Difference

    Banks use these rates to entice borrowers and investors. Find out what you're really getting.
RELATED FAQS
  1. How do mutual funds compound interest?

    Learn how mutual funds can grow wealth over time through the magic of compound interest by reinvesting dividends back into ... Read Answer >>
  2. Other than my savings account, what other types of holdings compound my interest?

    Understand the benefits of compounding interest, and learn the types of investments that offer compounding in addition to ... Read Answer >>
  3. How often is interest compounded?

    Understand what compound interest is and how the compounding of interest applies to the benefit of investors or creditors, ... Read Answer >>
  4. What formula can I use to calculate interest on interest?

    Find out more about compounding interest, what it measures and how to calculate the amount of compound interest accrued using ... Read Answer >>
  5. How do I use the rule of 72 to calculate continuous compounding?

    Find out why the rule of 72 does not accurately reflect the growth caused by continuous compounding, and which number can ... Read Answer >>
  6. What is continuously compounding interest?

    Read a quick explanation of continuously compounding interest rates, why compounding matters and how to calculate the continuous ... Read Answer >>
Hot Definitions
  1. Goodwill

    An account that can be found in the assets portion of a company's balance sheet. Goodwill can often arise when one company ...
  2. Return On Invested Capital - ROIC

    A calculation used to assess a company's efficiency at allocating the capital under its control to profitable investments. ...
  3. Law Of Demand

    A microeconomic law that states that, all other factors being equal, as the price of a good or service increases, consumer ...
  4. Cost Of Debt

    The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; ...
  5. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  6. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
Trading Center