Glossary
Compounding
Growth calculated on a total that already includes earlier growth, so each period's gain joins the base for the next one.
Simple growth adds the same amount every period. Compounding adds a percentage of a total that keeps changing, so the amount added grows even when the percentage does not. Ten percent of $1,000 is $100; ten percent of $1,100 the following year is $110, and the difference between the two paths widens every year after that.
The mechanism is arithmetic rather than a strategy, and it applies to anything that reinvests: a company retaining profits instead of paying them out, a fund reinvesting the dividends it receives, or a savings balance where the interest stays in the account rather than being withdrawn.
It runs in reverse too, which is the half that usually gets left out. A percentage lost has to be earned back on a smaller base, so a fall of 50 percent needs a rise of 100 percent to get back to level. The same arithmetic is why funds that reset their exposure daily drift away from the index they follow over long periods, an effect the industry calls volatility decay.
Related terms
- DividendA cash payment a company makes to its shareholders out of profits, most often once a quarter.
- Index FundA fund that mechanically holds whatever is in a published index, rather than having a manager choose holdings.
- VolatilityHow much a price moves around over a period, in either direction, measured as the size of the swings rather than the destination.
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