Imagine a world where your wealth increases on its own, without you having to lift a finger. It takes time for compounding to work its magic in real life but that doesn’t make this principle any less powerful.
Here’s a fact…
Do you know that if you invested between the ages of 21 and 30, then stopped forever, you would still have more money when you retired than if you started at 30 and stopped at 70 (based on a 7% annual return)*? This is all because of the power of compound returns. (If you’re over 21, this doesn’t mean it’s too late to start, but it does mean starting now so your money can begin to multiply as you sleep).
So, what is compounding?
Compounding is the return you get on your original investment and the return you get on your return. When you leave your returns to compound over time, your money can grow exponentially all by itself.
How does compounding work?
Suppose you invested £5,000 and it grew by 7% each year. At the end of the first year, you’d have £5,350.
At the end of the second year, you’d have £5,725 – that’s an additional £375 return – because you made gains on your original £5,000 and gains on your return from year one. That’s a compound return.
Leave that investment for the longer term – say, 25 years – and your £5,000 will grow to a massive £27,137. That’s more than a fivefold increase on your original investment. Now you’re really compounding!
Does this only happen when investing in stocks and shares?
Compounding can happen across all types of investments. The greater your returns the greater the impact of it. Here’s what shares (the blue line) versus cash (the red line) could look like over an 12 year period. In the stock market, where historical average returns per year for the last 10 years have been 7.5%, compounding has more of a chance to work its magic than cash that’s in a bank earning lower interest.
Time to lay down the law…
The Law of 72 is a helpful way to calculate the approximate time it takes to double your money at a given rate without adding one penny to your original investment – ever. To estimate the time required to double an original investment, divide 72 by the expected return rate.
For example, at 6% return, your money takes 72 divided by 6 = 12 years to double.
And, as we have seen, time in the market is what makes compound returns so substantial that Albert Einstein allegedly called it one of the most powerful forces in the universe, the eighth wonder of the world…
Quiz: At 8% annual return, how long will it take to double your money?
- It will take 9 years
- I’m over 21 so I will never be able to double my money
- 576 years
- Remember, the earlier you start, the more time your money has the potential to benefit from the compounding effect described above. You’ll feel better knowing you’re planning for your future – and, crucially, you’ll benefit from compound returns. As an example, if you were to invest £1,000 at 7% aged 40 and you’ll have £3,870 when you’re 60. Start ten years earlier, at 30 and you’ll have £7,612 – almost twice as much. However, remember these do not provide guarantees of future performance and are provided as examples to illustrate the power of compounding.
- Review your settings and make sure you’re investing what you can afford, on a regular basis, and let the power of compounding work for you.
*The FTSE All-World GBP from 2008 to 2017 would have given you an average return of 8.8% per year.
Quiz answer: 1
All investing should be regarded as longer term. The value of your investments can go up and down, and you may get back less than you invest. Past performance is not a reliable guide of future performance.