Compounding: A Mathematical Marvel
Compounding is the financial equivalent of a snowball rolling downhill: With each revolution the snowball gets bigger because it picks up more snow.
Compounding can produce a snowball effect with money. The potential earnings each year can contribute a little more to earnings the following year. As time passes, earnings can contribute more and more to the total value of an investment.
The basics of compounding
As an introduction to compounding, let's look at its impact on a hypothetical $15,000 investment in a money market fund earning 4% annual interest. We'll use a money market fund because the earnings are all interest, which makes the explanation easy to understand.
Please note: An investment in a money fund is neither insured nor guaranteed by the U.S. government or by any other entity or institution. Money market funds seek to maintain a $1.00 share price, although there's no assurance they will do so, and it's possible to lose money.
| Year | Value | 4% Interest | Interest Increase from Prior Year |
|---|---|---|---|
|
For illustrative purposes only; assumes all interest is reinvested. The concept of compounding is presented by using a hypothetical money market fund and is not intended to represent or predict the performance of any Franklin Templeton money fund. |
|||
| 1 | $15,000 | $600 | - |
| 2 | $15,600 | $624 | $24 |
| 3 | $16,224 | $649 | $25 |
| 4 | $16,873 | $675 | $26 |
| 5 | $17,548 | $702 | $27 |
| 6 | $18,250 | $730 | $28 |
These numbers may not seem like much to crow about, but notice that even though the interest rate stays the same, the amount of interest increases each year.
A long-term investor could see the value increase more and more with each passing year. That's because as the interest rate is applied to a larger amount each year, it generates a greater amount of interest.
Time can turn a little into a lot
Now that we understand the nuts and bolts of the math, let's look at how this hypothetical example plays out over a longer time frame. By reinvesting 4% annual interest for 30 years, a $15,000 investment can more than triple in value, to $48,651 at the end of the period.
Reinvest earnings and put your money to work
You may have noticed that our hypothetical assumes the interest payment is never taken in cash. Reinvesting the interest increases the value which, in turn, increases the amount of interest earned each year.
Just like our snowball growing larger with each roll, the value of the investment can increase by a greater amount each year as the interest is pumped back in. As time passes, interest on the reinvested interest can rival or surpass the interest generated from the initial investment alone.
Earnings Can Dwarf the Initial Investment Over Time
Hypothetical illustration of long-term effects of compounding
| After 5 years | After 30 years |
| Initial investment: $15,000 Earnings: $3,250 Account value: $18,250 |
Initial investment: $15,000 Earnings: $33,651 Account value: $48,651 |
 |
 |
Assumptions: $15,000 initial investment and 4% annual interest with all interest reinvested. For illustrative purposes only; does not represent or predict the performance of any Franklin Templeton fund.
The effects of compounding really stand out if you consider what happens when the interest is not reinvested. If you took the earnings in cash each year from a money market fund earning 4% annual interest, you'd receive $600 per year (or a total of $18,000) over 30 years.
On the other hand, if you reinvested the interest each year, it would generate an additional $15,561 in interest on top of the $18,000 generated by the initial investment over those 30 years.
Growth on top of compounding
For simplicity, we've used a money market fund to understand the basics of compounding because these funds try to maintain a stable share price. In our example above, we assume that principal and interest do not vary. But for other types of funds, these elements do naturally vary with market conditions.
So what's the impact of compounding on other kinds of mutual funds—such as funds that include growth as a goal but have share prices that fluctuate according to market movements?
The basic principles of compounding apply to any mutual fund. Namely, reinvesting earnings (dividends and capital gains for non-money market funds) over time can lead to potentially large increases in value.
If a fund's share price rises, your initial investment grows independently of the effects of compounding. Although there's no guarantee that a fund's share price will increase, coupling this kind of growth potential with compounding has been an effective strategy for many long-term investors.
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