What does “compound interest” or “compound returns” really mean?

It is a fairly simple concept. It means that any interest earned is added to the principal amount and any future interest is earned on the new principle value.

If we are talking about a bank savings account this has the same affect but the interest amounts are so small that it is not exciting at all. In fact, it is not even interesting! 1% or 2% interest is down right boring!

Where this becomes exciting is when you can get higher returns from investments like stocks and mutual funds. For example, if you own $1000 worth of a stock and the price increases by 10% you have a value of $1100, an increase of $100. Any future increases are based on that new value. If it increases another 10% the new value would be $1210, an increase of $110. This is compounding returns.

This also work in reverse when the values go down. When prices are decreasing the compounding is both a blessing and curse in my opinion. Using the same example, if you own $1000 worth of a stock and the price decreases by 10% you have a value of $900, a decrease of $100. Any future decreases are based on that new value. If it increases another 10% the new value would be $810, a decrease of $90. I see this as a blessing in that the future % deceases are are smaller value amounts. The total loss of value slows down. I see this as a curse in that it takes a larger % increase to get back to even.

The table below shows an even position of $1000 in the middle and 10 hypothetical periods of time going up and down from there. The lines above even show how % increases affect the value. The lines below even show how % decreases affect the value. The last two columns show the % Total Change and % Back to even.

From this we can see that if we have a 50% increase in value, it will only take a 30% decrease to take us back down to even. On the other hand, if we have a 30% decrease in value, it will take a 50% increase to get us back up to even. Understanding the affect of compounding returns is one key to investing.

Period % Per Period Value % Total Change % Back to Even
10 10.0% $2,594 159.4% -61.4%
9 10.0% $2,358 135.8% -57.6%
8 10.0% $2,144 114.4% -53.3%
7 10.0% $1,949 94.9% -48.7%
6 10.0% $1,772 77.2% -43.6%
5 10.0% $1,611 61.1% -37.9%
4 10.0% $1,464 46.4% -31.7%
3 10.0% $1,331 33.1% -24.9%
2 10.0% $1,210 21.0% -17.4%
1 10.0% $1,100 10.0% -9.1%
0 $1,000
1 -10.0% $900 -10.0% 11.1%
2 -10.0% $810 -19.0% 23.5%
3 -10.0% $729 -27.1% 37.2%
4 -10.0% $656 -34.4% 52.4%
5 -10.0% $590 -41.0% 69.4%
6 -10.0% $531 -46.9% 88.2%
7 -10.0% $478 -52.2% 109.1%
8 -10.0% $430 -57.0% 132.3%
9 -10.0% $387 -61.3% 158.1%
10 -10.0% $349 -65.1% 186.8%