“My wealth has come from a combination of living in America, some lucky genes and compound interest” - Warren Buffett.
Compound interest is simply interest on interest, but its impact is incredibly powerful: Albert Einstein reportedly described it as the eighth wonder of the world.
A simple example is a £1,000 investment paying 5% interest. After one year you would have £1,050. Then in year two, you would get 5% of £1,050, which is £52.50, totalling £1,102.50.
In year three you would get 5% of £1,102.50 which is £55.13, totalling £1,157.63. And so it goes on, accumulating interest upon interest, generating progressively larger returns as the interest compounds over time.
This leads to one of the most important implications of compounding – the need to start investing early. This means you will have as long as possible for the effects of compounding to work its magic.
For example, somebody investing £10,000 and leaving it invested in the stock market for 10 years, where it earned an average of 5% a year, would arrive at a total value of £16,288 after 10 years. That’s more than £6,000 profit accrued by leaving an investment alone and letting it grow.
But if it were left for 20 years, that same £10,000 would grow to £26,532, of which more than £16,000 is compounded investment returns.
Over 30 years the total balloons to £43,219, and over 40 years that original £10,000 investment would grow to £70,399, assuming the same 5% annual return.
As you can see, the returns on the investments are the same in percentage terms: the only difference is the time that the money is left in the market to benefit from compounding.
When it comes to compounding, time is everything, so don’t delay.
Liz Alley, divisional director of Financial Planning at Brewin Dolphin, says the message is simple – start early.
“It really is miraculous what a difference time makes to your investment,” she says.
”Delaying your saving by just a few years can have a dramatic effect on the sums you can accrue, so the earlier you start, the better it will be - both in terms of the amount you save, and avoiding the stress associated with trying to make up for lost time later on.”
The value of investments can fall and you may get back less than you invested.
Past performance is not a guide to future performance.
No investment is suitable in all cases and if you have any doubts as to an investment's suitability then you should contact us.
The information contained in this document is believed to be reliable and accurate, but without further investigation cannot be warranted as to accuracy or completeness.