Auto-compounding adds earned income back into an investment position without requiring a separate manual reinvestment each time. A DeFi vault may harvest reward tokens, exchange them for the strategy's deposit asset, and reinvest the proceeds. Other systems increase the earning balance through their accounting rather than a visible token transfer.
The effect of reinvesting
Suppose 1,000 tokens earn 1% per period for two periods, with an unchanged rate and no fees or losses. Reinvesting the first period's 10 tokens makes the second period start with 1,010 tokens. It then earns 10.1 tokens, producing 1,020.1 in total. Without reinvestment, the two periods would earn 20 tokens in total.
This illustrates compounding, not a promised market return. APR generally excludes compounding, while APY incorporates an assumed reinvestment schedule. A projected APY depends on that schedule and the underlying rate continuing.
Automation still has costs and conditions
Harvesting and swapping can incur network fees, trading costs, or performance fees. More frequent reinvestment is not automatically better after those costs. Execution may depend on a keeper or another trigger.
Automatically reinvesting also keeps the rewards exposed to the strategy. Asset-price declines, changing yields, withdrawal limits, and contract failures can outweigh the additional tokens earned.