Why compound annual growth matters

May 10, 2024

Harness the power of compound growth to increase your chances of long-term investing success.

Compound growth is an incredibly simple but powerful financial phenomenon that can help you meet your investment goals. Here’s how it works, what affects it and how you can make the most of it in your investing strategy.

What is compound interest?

When you make an investment, you hope it earns a return. For instance, a $1,000 investment might return 7% in year one, for a total gain of $70. The next year, you could reinvest the $70 gain for a total investment of $1,070. If that investment once again returned 7%, you’d end up with $1,145—a gain of $74.90. That’s because the $70 in returns from year one compounded to give you an extra $4.90.

Therein lies your opportunity: The return on your investment generates its own return. Said more simply, through the power of compounding, even your interest earns interest. This effect can grow stronger with time. 


Now, imagine the return after five years if you invest more than $1,000 initially. Or if you invest for 30 years instead of five.

Why is compound annual growth important?

Compound growth has the most impact on long-term investing since its effects increase as time goes on.

Using the previous numbers, let’s say you withdrew your returns every year instead of letting them compound in the investment account. In the example above, that would be a withdrawal of $70 each year.

Five years later, assuming a 7% return each year, you would have earned $350 in withdrawals instead of $403 in compound growth. After 10 years total, taking the returns each year without compounding would earn you $700. Letting your investment earn compound growth over 10 years would result in a gain of $968.

If you’re investing for a long-term goal like retirement, the way in which returns can compound significantly over time means you can do more with less. 

How to calculate compound annual growth

There’s a formula you can use to calculate the compound growth rate of an investment, which is referred to as the compound annual growth rate, or CAGR. It requires three inputs: the investment’s end value, beginning value and the time period.

Here’s the formula:

  1. Divide an investment’s end value by its beginning value.
  2. Raise the result to an exponent of one divided by the number of years, and then subtract one from the result.
  3. Multiply this result by 100 to arrive at a percentage.

CAGR = [(End value/Beginning value)^(1/# of years)-1]x100 = % growth

 

How to take advantage of compound annual growth

The single biggest way to benefit from compounding is to start investing as early as possible. If you want to retire with a certain amount of money, the earlier you start, the less you would have to invest initially. You may even be able to set aside less as you age and put more money toward other goals. The longer your investments have to compound, the greater the impact.

Here’s another illustration (again, using a yearly return of 7% as an example – see graphic below): Imagine you’re planning to retire at 70. If you invested your first $1,000 at age 40 and held it for 30 years, you’d have just over $7,613. If you had started at age 20, you’d have more than $29,458 at age 70 — and that’s without ever adding another penny.


Graphic is hypothetical and for illustrative purposes only.

 

The good news is even if you didn’t start early, you still have more time now than you will next year, or the year after that. The more you can put away today, the greater the opportunity for compounding to work.

 

How recurring investments help compound annual growth

One of the easiest ways to benefit from compound growth is to set up an automatic investing plan. As the name implies, this plan invests your money automatically at certain time intervals, such as each pay period.

Automatic investing is a common strategy for retirement saving. Here, you would have a certain amount of money automatically deducted from your pay and invested in your retirement plan each pay period. You can change the amount or frequency if your time horizon, investing goals or risk tolerance change at any point.

This strategy takes advantage of an investing concept known as buy-and-hold, or dollar-cost averaging, which tends to reduce the impact of market volatility on your portfolio and even out share prices over time. It also helps remove emotions from investing by taking the human element out of investing decisions, as well as the temptation to try to time the investment markets.

Want to learn more about investing? No matter your level of experience, we’ve got investing insights and advice to help you take your knowledge to the next level.

Related content

How do interest rates work?

Investment strategies by age

Asset classes explained: Cash, bonds, real estate and equities

Understanding yield vs. return

What type of investor are you?

A guide to tax diversification in investing

Robo advisors vs. financial advisors: How are they different?

Start a Roth IRA for kids

Investing myths: Separating fact from fiction in investing

ETF vs. mutual fund: What’s the difference?

4 times to consider rebalancing your portfolio

Effects of inflation on investments

How much money do I need to start investing?

7 diversification strategies for your investment portfolio

Saving vs. investing: What's the difference?

Why compound annual growth matters

How to start investing: A beginner’s guide

5 questions to help you determine your investment risk tolerance

What types of agency accounts are available for investors?

Disclosures

Start of disclosure content

Investment and insurance products and services including annuities are:
Not a deposit • Not FDIC insured • May lose value • Not bank guaranteed • Not insured by any federal government agency.

U.S. Wealth Management – U.S. Bank is a marketing logo for U.S. Bank.

The information provided represents the opinion of U.S. Bank. This is not intended to be a forecast of future events or guarantee of future results.

U.S. Bank and its representatives do not provide tax or legal advice. Your tax and financial situation is unique. You should consult your tax and/or legal advisor for advice and information concerning your particular situation.

U.S. Bank does not offer insurance products but may refer you to an affiliated or third party insurance provider.