Compounding

Compounding is growth in which each period’s gains build on earlier gains, so the base for future growth increases over time.

Compound interest: Interest calculated on both the original principal and previously accumulated interest. It is the financial form of compounding, with each period’s interest enlarging the next period’s base.
Time value of money: The principle that money available now has different value from the same amount available later. Compounding translates time and a rate of return into the future value of money.
Simple interest: Interest calculated only on the original principal, without adding prior interest to the calculation base. Unlike compounding, it does not earn interest on accumulated interest.
Sequence of returns risk: The risk that the timing of investment returns changes an investor’s outcome, especially when withdrawals occur. Withdrawals can interrupt compounding and make the order of returns consequential.
Principal (finance): The original amount of money borrowed or invested, before interest, fees, or returns. It is the starting balance on which the first period’s compounded gain is calculated.
Exponential growth: Growth in which the rate of increase is proportional to the current quantity. Compounding at a constant rate produces exponential growth over equal time intervals.
Present value: The current worth of a future cash flow discounted at a specified rate. It reverses compounding to compare future amounts in today’s terms.
Linear growth: Growth in which a quantity changes by the same absolute amount over equal intervals. Compounding at a fixed rate increases by larger absolute amounts as its base grows.
Volatility drag: The reduction in compounded growth caused by fluctuations around an average return. Equal average returns can produce different compounded outcomes when return volatility differs.
Interest rate: The proportion of a principal charged or earned over a specified period. The rate determines how much each compounding period adds relative to the current balance.

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