Compounding Interest

HOW COMPOUNDING BUILDS WEALTH FOR EVERY AUSTRALIAN

Introduction: Why Compounding Is the One Investing Principle Everyone Must Know
“Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.” These words, often attributed to Einstein, echo across generations for a reason. More than any market “secret,” compounding is the relentless engine that turns early and regular savings into long-term prosperity. And yet, research shows that a surprising number of Australians especially young people don’t fully grasp just how powerful this force is. Compound interest is an investor’s best friend but can be a borrower’s worst nightmare. For those who understand and use it, compounding becomes the greatest ally on the road to wealth.

Understanding Compound Interest: The Math and the Magic
At its core, compounding is delightfully simple: it’s the notion of earning returns not only on the money you invest, but also on the returns previously generated. It’s interest on interest, growth on growth a virtuous cycle where your wealth can accelerate over time, provided you reinvest your earnings. Each time you make a contribution or earn dividends or interest, your next return is calculated on a bigger base.

Let’s break this down with some familiar numbers: Suppose you invest $500 per year at 3% per annum. After 20 years, you’ll have accumulated nearly $13,838 well above your $10,000 of contributions. If the average return rises to 7%, the final sum climbs to nearly $21,933, with annual investment earnings in year 20 dwarfing those in year one. But introduce an upfront contribution say, $2,000 to kick off that same investment at 7%, and after 20 years, you’ll have nearly $29,672.

The upward curve becomes truly dramatic over long time frames. Given enough time, even modest regular investments can snowball into a sizable nest egg. As many advisers put it: the longer the period, the more it works. After 40 years, a strategy with regular contributions and a higher return compounds to an astonishing sum. This exponential acceleration is why prudent investors, regardless of starting income, can build meaningful wealth given time and discipline.

Growth Assets: Stronger Compounding

What you invest in matters almost as much as when and how much you invest. Over Australian financial history, growth assets shares and property consistently outperformed defensive assets like cash and bonds, especially when compounding works its magic over decades.

Growth assets like shares and property provide higher returns than defensive assets like cash and bonds over long periods, as their growth potential drives higher long run returns, compensating for their higher volatility. Since 1900, the $1 invested in Australian shares (with dividends reinvested) would be worth over $1,000,000 today, compared to just $994 for bonds and $272 for cash, simply because shares delivered higher, volatile returns that compounded over a longer timeframe.

Even over rolling 20 year periods, Australian equities have almost always outperformed cash and fixed income, despite periods of market turmoil. Historical Australian property returns are close to shares about 10.8% annualised since the 1920s, compared to 11.2% for equities again demonstrating compounding’s results with long-term exposure to productive, growing assets.

The message is clear: higher-returning, growth focused investments are essential to fully harness compounding. Volatility is the price of admission, but history leans heavily in favour of those who stay the course. This holds for superannuation as well: members who choose high growth investment options early in their careers tend to accumulate far larger balances than those who opt for overly conservative allocations.

Why Do So Many Miss Out? Behavioural Pitfalls and Common Mistakes

Despite compounding’s power, many Australians fail to take full advantage and the reasons are as much psychological as financial.

First, investors may be too conservative, sticking to cash or defensive assets that feel safer but offer lower returns and hence, less compounding potential. It’s common, especially after volatile market episodes, to “go to cash” and miss out on the periods when markets recover and compound growth resumes.

Second, starting late or saving too little at the outset is a costly misstep. The magic of compounding relies on time; each year delayed is a year lost for growth on past growth. Even small sums, invested early, can outpace much larger ones started later in life.

Third, many attempt to “beat the market” by timing entries and exits, or frequently trading in search of the next big thing. These efforts more often destroy wealth, as buy- high, sell-low behaviour takes hold when emotions overrule discipline. The result is missing out on market rebounds the very times when compounding has its greatest effect.

Lack of diversification is another common error.

Concentrated portfolios, or “putting all the eggs in one basket,” can reverse years of compounding progress with a single bad outcome. Cross-asset diversification mixing shares, property, cash, and fixed income provides a smoother, more resilient ride for the long run.

Finally, many get tempted by trendy investments promising a “free lunch,” only to discover that outsized returns often come with risks that jeopardize both capital and compounding prospects. Simple, disciplined, long-term investing in proven vehicles remains the best approach.

The fundamental behavioural challenge is resisting the short-term noise of markets, headlines, and social media. Emanuel Derman likened compounding to “letting tiny, invisible steps accumulate into a journey of a thousand miles.” Resilience staying invested through ups and downs is perhaps the most underappreciated investor skill.

Practical Steps for Every Investor: Harnessing the Magic Multiplier

Fortunately, the magic multiplier of compounding is available to every Australian, regardless of starting sum or market knowledge. Here’s how to ensure it works for you:

• Start Early and Invest Regularly: The earlier you begin, even with small amounts, the greater the compounding effect. Make use of regular or automated investment plans, salary sacrifice into super, or direct debit into managed funds or ETFs.
• Focus on Growth Assets for the Long Run: Allocate a substantial portion of your portfolio to shares and property, especially if you have many years until retirement. As AMP and Findex highlight, higher returns even if volatile are the engine behind outsized compounding over time.
• Increase Contributions as You Can: Any windfall, pay rise, or bonus is an opportunity to turbocharge your future with compounding. Even a single larger, early contribution multiplies wealth after years of returns on top of returns.
  • Diversify and Monitor Costs: Don’t bet everything on a single asset or sector. Balance shares, property, cash, and bonds to match your risk profile. Favour vehicles with low fees compounding works best when less is lost to costs.Stay the Course and Tune Out the Noise: Market declines are uncomfortable, but panic-selling defeats compounding. Understand that volatility is a feature, not a bug, with the patient investor typically emerging ahead. As Dr Shane Oliver puts it, “Invest a bit of time in understanding that short term volatility is a normal part of investment markets and partly explains why growth assets have a higher return in the first place.”
  • Learn and Review Regularly: Make use of adviser guidance, review your super investment options, and regularly check in on your goals. Avoid the urge to chase “get rich quick” ideas slow and steady nearly always wins the race.
• The most important decision is often to “do nothing” letting compounding work without unnecessary interference.

Conclusion: Compounding—the True Engine of Wealth

Of all the habits, tricks, and strategies in the investment universe, none rivals the long-term power of compounding. Like a snowball rolling downhill, it grows quietly and slowly at first, then with unstoppable momentum. The greatest wealth builders whether individuals, funds, or nations have succeeded by harnessing this simple, patient, repeatable process.

For every Australian, the message is clear: Time and discipline not luck or market wizardry are the foundation of a secure financial future. Start early, think long, invest steadily in growth, and let compounding do what it does best. In the end, the true magic multiplier is not found in complexity, but in the everyday choice to let your money, step by step, work for you year after year.

References

• Oliver’s insights – Compound interest and returns are an investor’s best friend, AMP, 2025
• Boost Savings with Compound Interest, AMP, 2025
• Harnessing compounding interest to grow your superannuation and investments, Findex, 2024
• Compound Interest is an investor’s best friend, Green Taylor Partners, 2025
• Investing in 2025: Compound Your Way to Happiness, BlackRock, 2025