Familiar with the 2000 martial arts classic Crouching Tiger, Hidden Dragon? The name comes from a Chinese idiom that describes hidden strength - powerful forces lying quietly beneath the surface, waiting to emerge.

That’s a perfect way to think about compound returns, commonly also referred to as compound interest. Quiet, slow-moving, almost invisible at first - but over time, they can unleash impressive financial power. Whether you’re growing wealth or carrying debt, compounding is always at work in the background. The trick is to make sure it’s working for you, not against you.

Crouching Tiger, Hidden Dragon can be likened to the power of compounding returns


What are compound returns?

Compounding returns are the earnings you make not just on your original investment, but also on the returns that investment has already earned. It’s where the money your money earns, earns more money! At first it can be quite small but over time it gathers momentum - like a snowball, or an exponential curve.

This can be great news if you’re investing. But if you’re borrowing it can quickly turn small debts into much bigger problems. It means you’re charged interest not just on what you borrowed, but also on any remaining interest you’ve been charged, so your debt keeps growing the longer you leave it.

Compounding: Friend and foe

Let’s look at two examples.

Mia borrows $3,000. She puts it on her credit card, which charges 18% interest. If she only pays the minimum repayments ($90/month), the interest she gets charged will compound and it will take her nearly four years to clear the debt. She’ll pay around $1,100 in interest on top of the $3,000 she has to pay back. That’s 37% more than the cost of the original amount she borrowed going to the lender.

Aidan invests $3,000. He puts it into a long-term investment returning 6% per year, after tax and fees. He adds $90 a month to his investment for 5 years and doesn’t take any out. By the end of the 5 years, his investment has grown to over $10,000 - almost $2,000 (20%) of that earned from compounding returns.

Why time matters for investing

In the world of martial arts, timing is everything. In the world of money, it’s the same - time is your most powerful tool. But often one that’s underrated in favour of “quick gains”.

That’s because compound returns don’t grow in a straight line. They accelerate. The more time you give them, the more your money can multiply. Let’s look at another example - two investors with the same end goal.

Gemma and Carter: Same savings, different results

The chart below tells the story of Gemma and Carter, who each invest $180,000 in total and plan to use the savings when they turn 55. But there’s one crucial difference: when they start.

• Gemma starts at age 25, saving $500/month

• Carter starts at age 35, saving $750/month
  

By age 55, they’ve invested the same amount total - but Gemma’s investment has grown to $407,688, while Carter’s sits at $304,353. That’s a difference of $105,335. Why? Gemma gave compounding a 10-year head start. Even though she saved less each month, she ended up with more - thanks to a longer time period and the snowball effect of compounding returns.

Figure 1: the difference between 10 years of earning compound returns. Figures in this chart have not been adjusted for inflation. Calculations are simplistic and assume a stable 5% annual rate of return, after taxes and fees.

Try playing with the numbers yourself: sorted.org.nz/tools/savings-calculator

How to make compounding work for you

• Start early. Time in the market is your best friend. The earlier you start investing, the more time compounding has to work its magic.
• Be consistent. Regular contributions - even small ones - really can add up. Consider setting up automatic payments, so you don’t even have to make an ongoing effort to grow your money.
• Leave it alone. The magic happens when your investment stays invested. The longer it’s untouched (or even better, added to regularly), the more compounding can do its work.
• Pay off debt quickly. Especially high-interest debt, like credit cards or personal loans. Compounding can be relentless in snowballing your debt - don’t let it build against you.
  
  

The hidden force in your finances

Albert Einstein reportedly called compounding interest the “Eighth wonder of the world.” He said, “Those who understand it, earn it. Those who don’t, pay it.”  

It may not roar. It doesn’t tend to make headlines. But over time, compounding returns can become one of the most powerful forces in your financial life. Use it wisely. Give it the time it needs. And let the hidden dragon that is compounding work for you.

The information provided and opinions expressed in this article are intended for general guidance only and not personalised to you. These materials do not take into account your particular financial situation or goals and are not financial advice or a recommendation. This article is not intended to convey any guarantees as to the future performance of any of the investment products, asset classes, or capital markets mentioned. Past performance is no guarantee of future performance. Information is current at the time of posting, and subject to change without notice. Simplicity NZ Ltd is the issuer of the Simplicity KiwiSaver Scheme and Investment Funds. For Product Disclosure Statements please visit our website simplicity.kiwi.