What is the effect of compounding on long-term investment growth?

• A. Returns generate additional returns over time; longer horizons maximize compounding, leading to greater wealth
• B. Compounding reduces risk
• C. Compounding only matters for short-term investments
• D. Compounding guarantees no losses

Answer: (A)

Compounding is when investment returns earn returns on themselves, so the amount earning future gains grows with each period. This creates accelerating growth because every period’s earnings become part of the base that earns more in the next period. The longer money stays invested, the more compounding cycles occur, and the larger the final amount. For example, with an 8% return, a $100 investment becomes about $216 in 10 years, about $466 in 20 years, and just over $1,000 in 30 years. This demonstrates how the base expands and the effect compounds over time, making long horizons especially powerful for building wealth.

Keep in mind that compounding does not reduce risk or guarantee against losses; it can amplify both gains and losses. It also matters in the short term, but its impact is far greater over longer periods.