1.2. How Money Can Work
Lesson objective
Understand growth, income, and compounding.
Invested money can produce results in two broad ways: it can generate income or increase in value. A stock may rise in price, and some companies also distribute dividends. A bond may pay interest. A savings account may generate interest with less variation, although usually with lower growth potential.
When returns are reinvested, they can begin generating additional returns. This effect is called compounding. Its strength depends on time, the rate earned, costs, and the consistency of contributions.
Compounding also works against the investor when debt is involved. Accumulated interest can increase an outstanding balance, so investing should not be considered separately from personal obligations.
Simple example
If $1,000 grows by 8% for one year, it becomes $1,080 before taxes and costs. If the return is reinvested and the account grows another 8%, the second year begins from $1,080 rather than $1,000.
Compounding is growth on top of growth
Future value = Principal × (1 + r)^n
| Year | $1,000 at a hypothetical 8% | |---:|---:| | 0 | $1,000 | | 1 | $1,080 | | 5 | about $1,469 | | 10 | about $2,159 |
Why time matters
At 8%, the first hypothetical year's gain is $80. Later, the same percentage applies to a larger base because prior gains remain invested.
The table assumes a constant return and ignores fees, taxes, deposits, and withdrawals. Markets do not deliver a fixed percentage every year. Compounding can also work against you through fees, debt interest, and repeated losses.
What you should remember
- Time magnifies both favorable and unfavorable results.
- Actual rates of return vary.
- Costs, taxes, and inflation reduce effective growth.
Practice
Use a compound-interest calculator and compare 5, 10, and 20 years using the same contribution.