During the second year, you're still getting your five per cent interest rate, but you get that return on $105, rather than just $100.
Each year you're getting interest on last year's interest too, so the returns are growing all the time, as is your pool of capital.
After 10 years, you've amassed $163, which is of course more than what your original $100 and 10 lots of $5 would add up to.
That might not seem like much, but over enough time the numbers start to snowball and the gains can become very, very impressive indeed.
Since 1945, US shares have delivered an average return of 11.2 per cent per annum. At that rate of return, you're doubling your money every 6.5 years.
In less than 20 years, that process has run its course three times, which means you've doubled your money, then doubled it again, then doubled it again. That $100 we started with has grown to $200, then $400, then $800.
The $100 investment left alone to compound at a return of 11.2 per cent per year for two decades has magically turned into $835 – an eightfold increase.
Granted, there will be taxes or fees along the way, and we all know that markets bounce around rather than moving in straight lines, but over the long term this is a recipe for wealth creation.
New Zealand shares haven't been far behind, returning 10.2 per cent annually over the past 50 years. That means an investor has had to wait 7.1 years, on average, to double their money.
Savvy investors who get their head around this simple (but extremely effective) concept are likely to do extremely well, especially if they figure it out early.
Consider friends Mick and Keith, both of whom put $50 a week aside as an investment.
Mick starts when he's 35, and he gets a six per cent annual return. When he turns 65, he's amassed a nest egg of $219,000.
Keith waits until 45 before he starts, although he does manage to achieve a much more impressive nine per cent annual return on his investments.
However, Keith hits 65 with only $146,000 - significantly less impressive than Mick. Mick's ten-year head start has given him an unassailable head start on his friend, and Keith would need to earn more than double Mick's annual return over his entire investing life to have any hope of catching up.
When it comes to investing, the single biggest factor that will determine your success is how early you start.
Many investors spend a lot of their time chasing the highest returns and looking for the best ways to make a quick buck. The truth is, your strongest ally in the path to wealth creation is time.
In this regard, younger people have a distinct advantage, if they choose to use it.
- Mark Lister is Head of Private Wealth Research at Craigs Investment Partners. This column is general in nature and should not be regarded as financial advice.
