Imagine a world where your money grows 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 it any less powerful. In fact, Einstein called compounding the eighth wonder of the world and Warren Buffett swears by it. So what is compounding and how does it work for your investments? Here’s what you need to know to make your money grow by doing nothing.
What is compounding?
Compounding – or a compound return – is the return you get on the gains from your original investment. To benefit from compounding, you’ll need to leave your gains invested rather than withdrawing them as profit. When you let your returns compound, your money can grow all by itself – and you won’t even have to lift a finger. 📈
Your cash savings can also benefit from compounding if you leave your interest payments in your savings pot – which will increase the total amount of money that you’re able to earn interest on in the future. Over time, your interest payments will increase. 🏦
How does compounding work?
Let’s say you invested £5,000 and it grew, hypothetically speaking, by 7% each year. At the end of the first year, you’d have £5,350 because 7% of £5,000 is £350.
At the end of the second year, your initial £5,000 would have grown to £5,725. So, in year one you made a £350 return but in year two it rose to £375 because you made a return on your original investment, plus on the £350 from year one – that’s compounding.
If you carried this on and left your earnings alone, you’d have £6,125 in year three, £6,554 in year four and £7,013 in year five.
In contrast, if you’d withdrawn the £350 gain on your original £5,000 investment each year as profit, you’d have earned a total of £1,750 in interest (at the same 7% per year) by the end of year five. This leaves you with a £6,750 investment pot – that’s £263 less than if you’d benefited from compounding.
How to make the most of compound returns
To make the most of compound returns, you’ll need to leave your initial investment alone for a long period of time. The more time that compounding has to do its thing, the more time it has to make your money work for you and the better your final return will be.
Using the same figures as the previous example, if you left your original investment of £5,000 at 7% annual growth alone for the long term – say, 25 years – it would grow to a massive £27,137. That’s over five times your original investment. Now you’re really compounding!
The Rule of 72 is a helpful way to calculate the approximate time it takes to double your money at a given rate without adding a penny to your original investment. To estimate the time required to double an original investment, divide 72 by the expected annual return.
For example, at a 6% annual return, your money would take 12 years to double (72 divided by 6) according to the Rule of 72.
How does compounding work with Moneybox?
With all Moneybox investing accounts, any gains are reinvested back into your funds automatically, so you haven’t even got to think about compounding – we do it for you. 🙌
Income vs accumulation funds
Many people wonder about the differences between income funds (sometimes called distribution funds) and accumulation funds. Put simply, accumulation funds will reinvest your gains into your total pot, so you’ll benefit from compounding without having to do anything. All of the funds that we offer at Moneybox are accumulation funds.
Income funds are slightly different. They pay dividends – which are a proportion of the fund’s total profits. Income funds put the focus on providing you with an income now, rather than looking to provide you with long-term growth.
Question one: How do you earn compound returns?
- Withdraw your earnings from interest as profit
- Leave your earnings from gains and interest in your total investment or savings pot
Question two: Does Warren Buffet follow the principles of compounding?
Question three: Finish this statement: ‘Compounding is most effective over the…’
- … long term
- … medium term
- … short term
Scroll down for the quiz answers!
🎓 You’re just one lesson away from completing the Moneybox Investing Academy! In our final lesson, we’ll look at pound cost averaging and how regular investing can help you capture the average return of the market.
Question one: Leave your earnings from gains and interest in your total investment or savings pot
Question two: Yes
Question three: Long term
All investing should be regarded as long term (minimum five years) and historic performance isn’t a guarantee of future returns. The value of your investments can go up and down, and you may get back less than you invest. We don’t provide investing advice, and investors should make their own investment decisions or contact an independent adviser.