The miracle of compounding

Can you guess how many times £1 would have to double to make £1,000,000? The answer, astonishingly, is just 20 times! But guess how much you would have if you doubled your initial pound 10 times? Believe it or not, it would be just £1,024.

This almost seems like some sort of voodoo, and in fact it has been referred to as the “eighth wonder of the world” by none other than Albert Einstein himself. But in financial terms, this is simply known as compound interest.

Compounding is a process of exponential growth, which is hard to grasp because as humans we think of growth in linear terms. This is why most people underestimate how quickly that pound can turn into £1,000,000, because the concept of exponential growth doesn’t naturally compute in our minds. The power of compounding also explains why it’s so important to start investing early and to give your investments time for that exponential growth to work its magic for you.

Let’s take a look at another example. If you invested £1,000 in a fund that returns 5% per year, in 12 months’ time you would have £1,050. But the next year, you would earn 5% on £1,050, taking you to a new total of £1,102.50. If you were to just leave this £1,000 in the same fund returning 5% a year for 40 years – voila, you would have £7,039.99, just by leaving it be! (Note, this doesn’t take into account the effect of inflation or fees).

The rules of compounding

But for this magic effect to work, there are a few key things to remember:

1. Sow the seed

Of course, first thing first: you have to actually invest money to see it grow. Just like a garden can’t grow without seeds, your investments can’t grow if you don’t give them a good base.

2. No time like the present

For best results, start as early as you can. For example, if you invested just £100 every month for 40 years and your investments happened to grow at 10% a year, you could end up with an impressive £563,987. Cue retirement and cocktails on a cruise ship! But if you did the same for 30 years you could have less than half at the end – £209,674.

3. Patience is a virtue

You can start with just a small seed and if you keep tending to your garden on a regular basis you might find yourself surrounded by lush flowers and sprawling trees. But it will take time, so it is very important to keep your hands off your investments! Yes, you heard us right. Forget that money ever existed. For a good long while at least.

4. Every little helps

As you might have noticed in the earlier examples, the annual return percentages haven’t been astronomical, but they are significantly higher than what you could expect to get in any savings account (please note that the returns are used for illustration purposes only and the value of your investments can rise as well as fall). It’s (hopefully) obvious that the higher the return each year, the higher the final amount will be. But the magnitude is perhaps not as obvious. For example, if you invested £100 a month at a 5% return, you could have £149,560 in 40 years’ time, but at a 12% return, you could have a whopping £988,612 (please note that the impact of fees and inflation are not reflected in these examples)! So choose your investments wisely and don’t forget that time is the other key component of this magic equation. And remember what we have said about time? It is your friend! And it is also a friend of more volatile asset classes that have higher expected returns, such as equities.

Now that you know about the miracle of compounding, you can easily work out how much you can expect to have in your pension pot when you finally retire, or how long it will take you to save up for a bigger home. There are tons of handy compound interest calculators available such as these ones. So go on, sow the seeds now and you may be able to grow a garden!

Date of publication: 30th July 2020