Compound interest and returns are an investor’s best friend
"Compound interest is the eighth wonder of the world. He who understands it, earns it; he who does not, pays it."
Attributed to Albert Einstein
If there is “one thing” investors should know about investing, it’s the power of compound interest or returns. In the ever-rising obsession with short-term developments impacting investment markets around the economy, interest rates, profits, politics, etc, it’s often forgotten about. It can be the worst nightmare of borrowers as interest gets charged on interest if debt is not paid down. But it’s the best friend of investors. The well-known Australian economist Dr Don Stammer refers to it as “magic”. Unfortunately, research by AMP shows many don’t understand the concept, particularly younger Australians with 2 out of 5 men under 40 responding in a survey that they don’t understand it and 2 out of 3 women. This is unfortunate as it’s when you are young you can make the most of it. Given its importance, this note has another look at what it is, how it works, various issues around it and why investors often miss out.
What Is Compound Interest?
Compound interest is simply earning interest on interest, or generating returns on past returns.
Any earnings received from an investment are added back to the original investment amount, allowing the total investment balance to generate further returns in future periods.
The concept is best explained through simple examples.
Suppose an investor contributes $500 each year and earns a return of 3% per annum.
After 20 years:
- Total contributions would be $10,000.
- The investment would have grown to approximately $13,838.
Now consider the same annual contribution invested in an asset returning 7% per annum.
After 20 years:
- The investment would have grown to approximately $21,933.
- Annual earnings in year 20 alone would be approximately $1,435, compared with just $403 in the 3% scenario.
Finally, assume the investor made an initial contribution of $2,000 at the beginning and then continued investing $500 each year while earning 7% per annum.
After 20 years:
- The investment would have grown to approximately $27,737.
- Annual earnings in year 20 would be approximately $1,815.
These examples are simplified and do not take into account factors such as inflation, taxation, fees or the variability of investment returns. Nevertheless, they clearly demonstrate the power of compounding.
Three Key Drivers of Compounding
The effectiveness of compounding is driven by three primary factors:
The Rate of Return
The higher the return, the greater the impact of compounding over time.
The Level of Contributions
The more money invested, particularly in the early years, the greater the long-term outcome.
In the example above, the additional $2,000 upfront contribution resulted in an extra $5,804 after 20 years.
Time
Time is perhaps the most important factor.
The longer returns are allowed to compound, the more powerful the effect becomes.
Time also helps smooth out the impact of short-term market volatility.
For example, after 40 years:
- The 3% strategy would grow to approximately $38,832.
- The 7% strategy would grow to approximately $106,805.
- The 7% strategy with the initial $2,000 contribution would grow to approximately $129,267.
This exponential growth is why compound interest is often described as "magical."
It also helps explain why younger investors generally benefit from maintaining growth-oriented strategies within superannuation and other long-term investments.
Compound Interest in Practice
Growth assets such as shares and property have historically generated higher returns than defensive assets such as cash and bonds.
This is because investors are compensated for accepting higher short-term volatility through potentially higher long-term returns.
According to AMP's analysis of Australian asset class returns since 1900:
- Cash has returned approximately 4.6% per annum.
- Bonds have returned approximately 5.7% per annum.
- Shares have returned approximately 11.7% per annum.
While shares are considerably more volatile, their higher returns have generated substantially greater wealth over time through compounding.
According to the analysis:
- $1 invested in Australian shares in 1900 would have grown to approximately $1,029,276.
- The same $1 invested in bonds would have grown to approximately $994.
- The same $1 invested in cash would have grown to approximately $272.
While few investors have a 125-year investment horizon, rolling 20-year return analysis consistently demonstrates that Australian shares have historically outperformed both cash and bonds over long periods.
Some Common Questions
What About Property?
Over long periods, Australian residential property has produced total returns similar to Australian shares.
Since 1926:
- Australian residential property has returned approximately 10.8% per annum.
- Australian shares have returned approximately 11.2% per annum.
What About Fees?
Investment fees reduce returns over time.
However, for Australian equities, franking credits have historically provided an additional benefit of around 1% per annum, helping offset some costs. These franking credits were not included in the historical return comparisons.
Are These Returns Sustainable?
Historical returns should not be assumed to continue indefinitely.
Future returns are likely to be lower than long-term historical averages due to factors such as lower interest rates and bond yields.
AMP suggests:
- Cash rates may average around 3.5% over the medium term.
- Bond returns may be constrained by current yields.
- Australian equities may generate returns closer to 8% per annum, comprising:
- approximately 4.5% from dividends and franking credits, and
- approximately 3.5% from capital growth.
Even at these lower expected returns, compounding remains a powerful force.
Why Do Investors Miss Out?
If compounding is so powerful, why do many investors fail to benefit from it?
There are several common reasons.
Being Too Conservative
Many investors prioritise safety and keep too much money in cash or term deposits.
While this may reduce short-term volatility, it can significantly limit long-term growth.
Starting Too Late
Delaying investing reduces the amount of time available for compounding and makes it more difficult to achieve long-term goals.
Trying to Time the Market
Many investors attempt to predict market highs and lows.
Unfortunately, this often results in buying when markets are expensive and selling when markets have already fallen.
Lack of Diversification
Concentrated portfolios can expose investors to unnecessary risks.
Chasing Unrealistic Opportunities
Investments that appear too good to be true often are.
Investors should be cautious of opportunities that rely more on speculation and investor enthusiasm than genuine underlying value.
Implications for Investors
There are several practical lessons for investors seeking to benefit from compounding.
First, adopt a long-term investment mindset and focus on growth assets with strong long-term track records.
Second, contribute regularly to investments and superannuation, and begin as early as possible.
Third, develop strategies to manage market volatility and remain committed to long-term investment plans during periods of uncertainty.
Finally, avoid investments that appear excessively risky or unrealistically promising.
Compounding works best when given both time and discipline.
Source: Adapted from insights by Dr Shane Oliver, Head of Investment Strategy and Chief Economist, AMP (Published 21 August 2025).
General Advice Warning: This article contains general information only and does not take into account your personal objectives, financial situation or needs. Before making financial decisions, you should consider whether the information is appropriate for your circumstances and seek professional advice where required.