Compounding is one of the most important tools in successful long-term investing. Even Einstein stated its importance, calling compound interest “the eighth wonder of the world”.
Compound interest is simply interest on interest, but its impact, as Jill Ellicott has said, can be “mind-blowing” and every financial expert would agree.
Read on to understand how compounding works, what makes it vital to wealth creation, and why it’s important to ensure you stay on the right side of it if you want to grow your wealth.
A simple example of a £1,000 investment paying 5% annual interest
If you invest £1,000 in an investment paying %, after one year you will have £1,050.
After two years, you would get 5% of £1,050, which is £52.50, giving you £1,102.50 invested.
After three years, you would get 5% of £1,102.50, so £55.13, giving you a total of £1,157.63 and so on…
The longer you stay invested, the larger returns you will enjoy as the returns compound over time. The above calculations don’t take any investment fees into account.
Time is key – the longer you stay invested, the better
As you can see from above, time is key to making the most of compounding. Investing early means you have the longest possible time for compounding to work its magic and grow your wealth.
This is why many financial planners advise parents and grandparents to invest for children early in their life. If you are saving for your children or grandchildren, investing the money wisely can help grow the money far better than you might expect if you leave cash in a bank or building society account.
For example, if you invest £10,000 in the stock market over two decades, and your investments earn an average of 5% a year after charges, after 20 years your investment would be worth £26,532. More than £16,000 of this would be compounded investment returns.
Invested for 30 years, the total of your investment would mushroom to £43,219 and over 40 years that original £10,000 investment would grow to £70,399, assuming the same return of 5% a year after charges.
How compounding works
*Assumes 5% annual return after charges
Left to work for long enough, compound interest can generate impressive returns. The longer you remain invested, the more interest you will generate.
Remember, these are hypothetical examples. The stock market goes down as well as up, and you could get back less than you invested. However, history shows that over periods of 10 or more years, the stock market tends to recover and perform more strongly than cash.
How to benefit from compounding
Another brilliant thing about compounding is that you don’t need to do much to benefit once you invest your money.
In fact, doing nothing is the best decision you can make. Simply leave your money invested and let the magic happen.
If you have diversified your investments enough and your portfolio is aligned with your financial goals, you can sit back and let time do its work.
One of the best ways to benefit from compounding is to invest monthly. Making regular investments, even small amounts, can be a great way to help teach children or teenagers about the benefits of saving and investing money.
It’s important to stay on the right side of compounding
If you’re on the wrong side of the compound game, it can damage your wealth.
Credit card interest is a prime example of this. If you have an outstanding balance on your credit card and have to pay 20% interest on the balance each year, this 20% interest compounds against you and erodes your wealth.
In year one of having an outstanding balance, you pay 20% interest on the balance. In year two, you’ll owe interest on the interest you let accumulate in year one and so on until you repay the debt.
Left unchecked, it’s easy to end up in a vicious cycle of paying interest on interest with ever-increasing debt.
With any debt, you should always aim to repay it as quickly and cheaply as possible, but this is especially true when it comes to credit card debt.
If you had a debt of £3,000 on your credit card (and made no further payments using the card), it would take you 27 years to pay off the debt if you relied solely on the minimum repayment. This would include an interest cost of almost £4,000.
The table below shows how this breaks down in reality, based on £3,000 debt at .9%, with minimum payments of 1% of the balance plus interest.
Every pound you have to spend repaying debt is a pound that’s no longer invested to work for you. Of course, avoiding expensive interest on credit cards will also leave far more money in your pocket in the long term.
If you have money to invest and delay investing it for even a few years, it could have a dramatic effect on the amount you accrue. The earlier you start, and the more you can save, the better.
Get in touch
To begin building your wealth and benefiting from the miracle of compounding, get in touch and talk to one of our expert financial planners. Email email@example.com or call us on 01275 462 469.
The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.
Bowmore Financial Planning Ltd is authorised and regulated by the FCA.