Compounding is the process where returns earn further returns over time. As interest or investment growth is added to the original amount, future growth is calculated on the larger balance, so gains accelerate the longer money is left invested.
In one line: Compounding is growth earning further growth, so returns build on a steadily larger balance over time.
How compounding works
Compounding underlies how savings interest and investment growth accumulate and is reflected in figures such as the AER on savings accounts. The key driver is time: more years means more cycles of growth on growth.
For example, 10,000 GBP growing at 5% a year reaches about 16,289 GBP after ten years, not 15,000 GBP, because each year's growth is added to the base that the next year's 5% is calculated on.
Charges compound too, in reverse, so a small annual fee difference can erode a meaningful share of a pot over decades.
Compounding in practice
Simple interest pays only on the original sum, while compounding pays on the original sum plus all previously earned returns, which is why long horizons matter so much.
Reinvesting dividends rather than taking them as cash is one way the compounding effect is captured inside pensions and ISAs. The earlier money is invested, the more cycles of growth it benefits from, which is why starting sooner often matters more than the amount.
Primary source: FCA: Investing basics