Compound interest: why it gives nothing in the early years

Compound interest is income earned on income. The definition is trivial; the behaviour is not intuitive: the mechanism barely shows over a short horizon and decides the outcome over a long one.

Why nothing is visible at the start

In the first year income accrues only on the amount invested — there is nothing yet to reinvest. In the second, income on last year's income is added, and that addition is small. It becomes noticeable when the accumulated income is comparable to the original investment — and that takes a while.

{{figure:compounding|caption=The gap between the lines is barely visible in the early years and decides the outcome in the later ones}}

What breaks the mechanism

Three things, and all three are the investor's own doing.

Withdrawing income. A coupon or dividend that is spent rather than put back drops out of the mechanism. The portfolio keeps working, but it grows in a straight line.

Costs. A fee behaves like compound interest with the sign reversed: it too is charged every year and it too accumulates. See Fees: small numbers that decide the outcome.

Interruptions. Selling the entire portfolio during a fall resets the accumulated base, and after returning to the market the count starts again from zero.

What follows in practice

The horizon matters more than the rate. A difference of one percentage point a year over a decade counts for less than the difference between holding on and getting out halfway.

And second: reinvestment should be the default rather than a separate effort. Coupons and dividends settling in the account are a common and invisible leak.