Compound interest is the principle where your returns generate returns on previously earned returns. It's the mechanism by which small amounts grow into large sums over long periods. Einstein supposedly called it the eighth wonder of the world, and while that quote probably wasn't his, the sentiment is accurate.
How does compound interest work?
With simple interest, you earn returns on your original investment. With compound interest, you earn returns on your investment plus all previously accumulated interest.
An example: you invest 10,000 euros at 7% per year.
- After year 1: 10,000 + 700 = 10,700 euros
- After year 2: 10,700 + 749 = 11,449 euros (you now earn interest on 10,700, not on 10,000)
- After year 10: 19,672 euros
- After year 20: 38,697 euros
- After year 30: 76,123 euros
Without any additional contributions, your original 10,000 euros has more than septupled after 30 years. The returns in the last 10 years are greater than in the first 20 years combined. That's the snowball effect of compound interest.
The Rule of 72
A useful rule of thumb: divide 72 by your annual return to find out how many years it takes for your money to double.
- At 6% return: 72 / 6 = 12 years to double
- At 8% return: 72 / 8 = 9 years to double
- At 10% return: 72 / 10 = 7.2 years to double
This also makes it clear why costs matter. The difference between 7% and 6% return (due to 1% higher costs) will cost you tens of thousands of euros over 30 years.
Compound interest in investing
In practice, compound interest works through three channels when investing:
- Price appreciation: your stocks increase in value. Last year's appreciation becomes part of this year's base.
- Reinvested dividends: you receive dividends and use them to buy additional shares. Those extra shares in turn generate their own dividends.
- Periodic contributions: by contributing monthly through dollar-cost averaging, you increase the base on which compound interest works.
Why time matters more than amount
Two investors:
- Anna starts at age 25 with 150 euros per month and stops at 35. Total investment: 18,000 euros.
- Bart starts at age 35 with 150 euros per month and continues until 65. Total investment: 54,000 euros.
At an average 7% return, Anna has more at age 65 than Bart, despite investing three times less and stopping 20 years earlier. That's the power of starting 10 years sooner.
The enemies of compound interest
- High costs: management fees, transaction costs, and taxes eat into your returns. Choose low costs (ETFs instead of actively managed funds).
- Interruptions: every time you sell and re-enter later, you interrupt the compounding effect. Consistency beats timing.
- Inflation: compound interest also works against you. If prices rise 3% annually, you need at least 3% return just to maintain your purchasing power.
- Procrastination: every month you don't start is one less month of compounding. There's no better day to start than today.
Compound interest is not a strategy. It's physics. It works always, for everyone, regardless of how much you have to invest. All it needs is time and consistency. The math takes care of the rest.