“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 can be incredibly powerful: Albert Einstein reportedly described it as the eighth wonder of the world.
A simple example is a £1,000 investment paying 5% annual 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.
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It pays to start early
This leads to one of the most important aspects of compounding – the need to start investing early. This means you have as long as possible for compounding to work its magic.
For example, somebody investing £10,000 in the stock market over two decades, earning an average of 5% a year after charges but before inflation, would arrive at a total value of £26,532 after 20 years, of which more than £16,000 would be compounded investment returns. Over 30 years the total would balloon 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 but before inflation.
Bear in mind that 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 ten or more years, the stock market tends to recover and perform more strongly than cash.
Investing for the long term
In the above examples, the returns on the investments are the same in percentage terms – the only difference is the length of time the money is left in the market.
Delaying investing by just a few years could have a dramatic effect on the sums you accrue, so the earlier you start, the better – both in terms of the amount you save, and avoiding the stress of trying to make up for lost time later on.
Beginning your investment journey can be daunting, so if you’re unsure how to get started, speak to one of our financial advisers today.
How compounding works
*Assumes 5% annual return after charges
Source: RBC Brewin Dolphin
The value of investments, and any income from them, can fall and you may get back less than you invested. Neither simulated nor actual past performance are reliable indicators of future performance. Information is provided only as an example and is not a recommendation to pursue a particular strategy. Forecasts are not a reliable indicator of future performance.