The Magic of Compound Returns
“Those who understand compound interest are destined to collect it.
Those who don’t are doomed to pay it.“
So, what is compound interest?
Albert Einstein, well known for being smarter than the average bear, once called compound interest “the greatest mathematical discovery of all time”. But you don’t need to be as intelligent as Einstein to understand compound interest. In fact, it is a very simple concept.
When you invest money you earn interest on your capital. The next year you earn interest on both your original capital and the interest from the first year. In the fifth year you earn interest on your capital and the first four years’ interest. You get the picture. The concept of earning interest on your interest is the magic of compounding.
It’s very much like using a snowball to build a snowman. As your capital rolls down the hill it becomes bigger and bigger. Even if you start with a small snowball, given enough time, you can end up with an extremely large snowball indeed.
At FFP, we show clients the magic of compound returns and although a 2% difference in return might sound a very small number, over a period of 10, 20 or 30 years, the difference becomes a very large number. The difference in returns doesn’t have to just be from the investment performance, it could be from a mixture of other factors such as lower investment costs and paying less tax.
The table below demonstrates the magic of compound returns and the difference between a return of 5% and 7% on £100,000 over a 30 year time frame.
The 5% return would have seen your £100,000 increase by over four times its original amount increasing to £432,194.
The 7% return would have seen your £100,000 increase by over seven times its original amount to £761,226. The returns payable in the 30th year up to a whopping £49,800!
The small number of just 2% would have provided you with an extra £329,032!
Here are 5 helpful tips to make the magic of compound work for you:-
The earlier you start saving and investing, the more time you leave for the magic of compound returns to take effect. Someone who invests £100 per month from age 20 to 29 and then lets their investments grow is likely to have more money at age 60 than someone who invests £100 a month from age 30 to 59.
Small Difference in Returns Matter – A lot!
As demonstrated above over long period of time the difference between 5% and 7% is enormous.
Don’t Spend Everything – We call it delayed gratification
Investing isn’t everything. Like most things in life it is best to strike a balance so it’s getting the right balance between enjoying yourself now and providing for your future.
Over time, regular saving of quite small amounts can build up to a large sum of money
If you save £100 per month for 40 years and your investments compound at 10% a year how much would you have? The answer is an astonishing £559,461.
Time and patience are the friends of compounding and, therefore, of investing
Saving for 30-40 years is obviously something you can’t do overnight. You have to exercise patience and discipline if you want to see the full benefits of compounding returns.
Although there are plenty of calculators available online to help you work out the effects of compound interest there is also a handy shortcut known as the Rule of 72. It states that you can find out how many years it will take for your investment to double by dividing 72 by the percentage rate of growth. So it will take 9 years for your investments to double if they grow at 8% a year (72/8=9). But it will only take 6 years if your investments grow at 12% and so on. The Rule of 72 only provides an approximate answer but it is sufficiently accurate for many calculations.
An important role of a Financial Planner is to ensure you are patient and disciplined so you achieve your goals, no matter how big or small they might be. A good Financial Planner will meet with you at least once a year to ensure you stay on track!