Investing early and harnessing the force of compound interest can lead to rapid gains
Albert Einstein reputedly once said: “Compound interest is the eighth wonder of the world. He who understands it, earns it, he who doesn’t, pays it.” That’s not the only thing he is reported to have said about compounding; when allegedly asked what the most powerful force in the universe was, his response was: “compound interest.”
Whether or not Einstein uttered these words is moot – it’s generally considered unlikely. However, savvy investors have long applauded the sentiment. Compounding means reinvesting interest or dividends to create a snowball effect that can see your money grow faster.
The good news is you don’t need to be a Nobel Prize-winning theoretical scientist to grasp the basics. While the mental arithmetic involved to calculate compound interest can seem mind-boggling – taking into account the principal sum, the interest rate, period of investment and any top-up savings you might make along the way – online compound calculators can always help.
Interest on interest
Eleanor Ingilby, Portfolio Manager at atomos, says: “The best way to explain compound interest is that it is the ongoing interest paid on the interest. That means that interest increases over time, as long as no money is withdrawn from the portfolio or bank account.”
The snowballing effect of compounding makes a case for long-term investments and biding one’s time as the interest escalates. Ingilby adds: “The main lesson investors can take from this is that the earlier you start to save, the greater the effect of compound interest. However, compounding only works if you keep the initial sum originally invested and reinvest any interest or dividend returns applied to it.”
With interest rates currently low, savings bank accounts are not very attractive. However, the compounding principle works just as well with investments if you reinvest the dividends. You can leave funds in your portfolio and let time and compounding do the work.
When markets turn volatile it can sometimes distract investors from their long-term objectives. Ingilby adds: “When markets drop it scares investors, and they often get a natural desire to pull their money back out again, but a part of compounding is going through the ups and downs.”
Compounding in action
One of the best ways to show the power of compounding is to look at how an investment performs over different time periods.
Three people, Sally, Anne, and John, invest £100,000. Sally starts saving at the beginning of a 20-year period; she invests her sum with a 6% annual rate of return, and then adds in £5,000 each year after that. Ingilby explains: “If you look at the graph it shows the dramatic difference of saving early, not taking anything out, and letting that interest mount up. Sally, who started in year one with £100,000 would have accrued £471,359.91 at the end of 20 years.”
Anne, who started investing in the seventh year, saved the same principal amount. Adding £5,000 at the same level of interest, she would end up with only £307,000. And then John, who invested in the 12th year (again putting in the same amount), ended up with £208,000, which is a vast difference in comparison to Sally’s balance at the end of 20 years.
If Sally were not to add in the extra £5,000 each year, the annual interest alone just on the initial £100,000 in year 20 would be £18,153, while the balance would be £320,713. Ingilby says: “Even if you don’t pay in the annual amount, it is about taking advantage of your initial investment.”
Conversely, compounding can also increase debt. Ingilby adds: “While compound interest works well for investors, it can also work against those who have debts and liabilities. Say you take out a loan and the interest on it is 6%, and you don’t pay anything back on the loan, that 6% is added to the amount owed and then you get charged another 6% already added to the amount. Your debt slowly increases by doing nothing. It shows the effectiveness and advantage of paying off your debts as soon as possible.”
Research carried out in the US by the George Washington University in 2016 found that only a third of Americans understand how compounding works. While there is no equivalent study in the UK, research by the Pensions and Lifetime Savings Association in 2018 revealed that 80% of Britons are not saving enough for retirement. Could a proper grasp of compounding’s power change that?
Ingilby explains: “I don’t think many people fully understand the massive impact it can have to start saving early, even if it is just an initial amount and just letting that money grow. Compounding is an incredible concept.”
On that basis it is worth heeding the advice of another formidable scientist; this time from the polymath and one of the US Founding Fathers, Benjamin Franklin: “An investment in knowledge always pays the best interest."