Personal Finance

Compounding: Why it Matters

Apr 12, 2017
Compounding: Why it Matters

Einstein is once believed to have said “The most powerful force in the world is compound interest”, and without hesitation, Buffet responds “Compound interest” whenever asked for the single largest factor behind his success. Such illustrious minds have rarely been wrong regarding their prospective fields, and thus we should indeed sit up and take note.

It is important to start putting aside some capital as soon as you can, whether this is for upcoming goals, such as weddings, or long term aspirations, such as that yacht, investing matters. The trick is to start small, and more importantly, as soon as you can.

This way, you can take the most advantage out of compound returns, and the almost magical effect on your capital growth. This is long term thinking, and the amount you put in now is less important compared to how long your money has to grow.

The idea of compound interest is that money makes money, you can earn interest on interest earned at, for example, your local bank account.

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The chart above shows the staggering differences between starting to invest at 25 and 35 years of age, and the outcomes based on retiring at 65. It shows how one saver, who invests for 10 years, end up with more total capital than Bill, who spent 30 years.

The same principle works when you invest in stocks or mutual funds, where annual returns are, on average, higher than they are at the bank. With compounded returns, the money your investments earn one year will earn money for you in following years — as long as you reinvest it.

Here are a few more examples with varying rates of returns:

For example, if you invest 100 pounds a month for 40 years at a modest 5% rate of return, you will have more than 150,000 pounds in total.

At 6%, almost 200 000.

Assuming you make good investments, at 10%, almost 600 000.

On a total investment of 60 000, this is 10 times the initial investment.

This often leads to the question of “Why don’t retirement savings work the same way, providing similar returns?”.

The truth is some do, there are some great funds that have performance at around these levels. One example is Horizon Capital, who generated returns of 24% over the last 12 months in its high risk fund.

Otherwise, it is likely that these returns are being made, but that the fees charged by brokers, traders, and wealth managers often leave the investor with very little reward.

To end with a final quote, “The aim of the wise is not to secure pleasure, but to avoid pain.” – Aristotle, and that’s why compound interest matters.