Compound Interest 101 – the gift that keeps on giving
Notwithstanding the unprecedented amount of information and data available to the DIY investor, there are really only a small number of factors that can make a significant difference to the outcome of an investment regime – the amount to invest, the % return on investment achieved and the duration of the investment.
However, investors with a long time horizon can benefit from what Albert Einstein once called the ‘greatest mathematical discovery of all time’ – compound interest.
More and more DIY investors are taking personal control of saving for their retirement and with the Bank of Mum and Dad (BOMAD) increasingly called upon to help the fruit of their loins with student finance and getting on the property ladder, there has never been more pressure on parents to establish a savings regime on their behalf.
‘greatest mathematical discovery of all time’
However tough we thought we had it, spare a thought for those recent graduates, trying to make their way in the world with the burden of student debt, astronomically high accommodation costs and constantly reminded that they will be facing abject poverty when they retire unless they set aside the large chunk of their salary that they could well do with to pay their extortionate utility bills.
The good news is that with a relatively long investment horizon, parents may be able to achieve higher returns by selecting slightly riskier investments, and compound interest has time to deliver maximum benefit.
It’s tough, but whether you are planning for your own financial future or looking to give a loved one a head start, compound interest comes as close as is possible to ‘money for nothing’ – and you can only start from where you are.
How Compound Interest Works
Compound interest is the multiplier effect of interest being earned on interest, over time; the higher the interest rate and the longer the period of saving or investment the greater the end result.
It has been likened to a snowball effect – capital rolling down a hill and gathering interest; however small it may start it is possible to achieve a very large snowball if it rolls downhill for long enough.
For example a saver putting £100 into an account paying 5% interest would have a balance of £105 at the end of the year; 5% interest on £105 adds £5.25 in year 2 and so on:
|Year||Principal||Interest @ 5%||Total|
If interest had been added only to the principal sum a ten year investment at 5% would have yielded just £50 whereas compounding ‘miraculously’ yielded almost £163.
OK, so that may not be a game changer, but what if you add to that original savings pot by an additional £100 per year, and you build a portfolio of investments that delivers 10% per annum in a tax efficient environment. Then things look a little different:
|Year||Principal||Additional Investment||Interest @ 10%||Total|
By maintaining an additional investment of £100 per annum, certainly things start to look a little more interesting and as amounts increase and time horizons are extended, compound interest can make a dramatic difference to your financial outcomes.
Time is the key to generating such momentum – in the above example £1,000 is invested in £100 tranches over a ten year period; however, if this sum had been invested in a lump sum at the outset, compound interest would have turned that into £2593.74 – not to be sniffed at and all the more delicious if it’s sheltered from HMRC in a tax efficient wrapper.
There are currently believed to be 200 ISA millionaires in the UK – Barclays Stockbrokers has the most with 69, and one Hargreaves Lansdown customer has topped £2 million – and that this number is set to swell to more than 2,000 as savvy DIY investors take advantage of low platform fees and generous annual investment allowances.
‘‘mony a mickle maks a muckle’ – over time, regular saving of quite small amounts can build to a considerable amount of money’
With subscription limits hiked to £20,000 for tax year 2017/8 – ISAs are clearly something the government is keen to encourage, and are increasingly being seen as a viable and flexible alternative to traditional pension savings accounts.
Fidelity International recently estimated that it would now be possible for those subscribing to the max and achieving 5% investment return, to amass a seven figure pot in just 24 years.
To see the difference compounding can make to an investment try the calculator here
Some key considerations
In order to take maximum advantage of compound interest there are some key factors to consider – most are common sense and others can be applied more generally as good practice for DIY investors:
- Start early – the earlier you start investing the greater the ‘miracle’ of compound interest; someone who invests £100 a month from age 20 to 29 and then lets their investments grow is likely to have more money at 60 than someone who invests £100 a month from age 30 to 59.
- Take care of the pennies – small differences in return can make a huge difference over time; the difference between investing at, say, 7% and 8% is enormous – try out the calculators here to see the difference.
- Strike a balance – unless it is your sole motive force, balancing long term investment with living for the moment will make the whole process feel less onerous.
- Remember – ‘mony a mickle maks a muckle’ – over time, regular saving of quite small amounts can build to a considerable amount of money; £100 per month achieving 6% investment return over 25 years returns over £70,000 – on £30,000 invested.
- Time in the market – the longer the duration of any investment, the greater the benefits of compounding and the less vulnerable a portfolio is to short term market volatility.
Compound Interest in Action
To highlight the differences, let’s consider the potential outcomes that could be achieved by a steady and disciplined investor, James, and a rather more profligate cove named Jeremy.
James invests £2,000 per year into an ISA from the age of twenty five until he stops investing at age thirty five and he never adds to his pot again.
He then leaves his investment untouched to grow until his retirement; achieving an average return of 7% over the 40 years of his investment means that James’ fund is worth £225,073 by the time he retires.
By contrast, Jeremy spent much of his hard-earned cash in his twenties on fast cars, wine, women and song – some he even wasted. He came late to savings and investment but when he did so he did it with gusto, tucking away £2,000 per year for each of the thirty years from age thirty-five.
Jeremy achieved the same 7% average return on his investments, but despite having invested three times as much as James – £60,000 against £20,000 – the value of his pot at stumps was just £202,146 – around 11% less.
That really is compound interest in action and it is not difficult to see how harmful inaction can be when there is the most benefit to be gained from savings and investment – when you’re young.
‘something is better than nothing and sooner is always better than later’
On the grounds that you can only start from where you are, the DIY investor should grasp the nettle and work out what an investment regime needs to look like to enable you to achieve your personal goals.
When faced with the prospect of setting an unrealistic proportion of salary aside because of coming late to retirement planning, many simply do nothing, and that can never be the right decision; something is better than nothing and sooner is always better than later.
If we revisit the example above, by year ten the annual interest earned is greater than the initial investment and by year thirty the results can be truly stellar.
|Year||Principal||Additional Investment||Interest @ 10%||Total|
However difficult, it is not impossible to achieve a 10% return on investments – particularly if a long time horizon allows you to explore the gamier parts of the risk/reward curve; that’s £20,000 for an investment of just £100 per month over thirty years – £3,000 invested.
The above calculations do not take account of fees or taxes, but are useful as an illustration.
Since 1869 the stock market has returned an average of 9% p.a. (a real rate of return of 6% when adjusted for inflation) although there has been greater variation over shorter time periods; average annual 20-year returns during this period have varied from as low as 3% to as high as 20% and even over 50-year periods, returns have varied from around 5% to 14%.
‘those who understand compound interest are destined to collect it; those who don’t are doomed to pay it’
Admittedly to achieve consistently better results from the stock market than the majority of the professionals do may be a big ask, but even more modest returns can make a big difference over time; certainly with some judicious planning and diversification the DIY investor can hope to do significantly better than the savings rates to be found on the High Street.
The amount to invest, return on investment and time in the market are key factors in the success or otherwise of an investment strategy; the very significant icing on the cake is delivered courtesy of compound interest and those planning for their own future, or aiming to give their loved ones a financial head start in life should get to grips with the very real difference that compound interest can make.
There is a flip side to compound interest – Einstein’s other contribution on the subject was ‘those who understand compound interest are destined to collect it; those who don’t are doomed to pay it’ and that will particularly strike a chord with those facing 6.1% interest payments being applied to their student debt from September this year meaning that a very large number will simply never be able to make repayments that keep ahead of the interest that is applied – more
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