What effect does compounding have on investments?

Compounding plays a significant role in enhancing the growth of investments by allowing interest to earn interest over time. When an investment generates returns, these returns can be reinvested, leading to more significant overall growth as the new principal includes the initial investment plus any accumulated interest. Over time, this process can lead to exponential growth as each period's interest earns additional interest in subsequent periods.

For instance, if you invest $1,000 at an annual interest rate of 5%, at the end of the first year, you would earn $50 in interest, bringing your total to $1,050. In the following year, the interest would then be calculated on $1,050 instead of just the original $1,000, potentially leading to even higher growth over time. This characteristic of compounding underscores the importance of time in investing, as the longer the investment can compound, the more pronounced the effects become, resulting in accumulating wealth more effectively.

This understanding of compounding is fundamental for making informed investment decisions and illustrates why long-term investing is often encouraged.