The Magic of Compound Interest
Are you making the most of your investments?
Compound interest is often called the eighth wonder of the world because it seems to possess magical powers like turning a penny into £5 million. The great thing about compound interest is that it applies to money and helps us to achieve our financial goals, whether they are so ambitious as to become a millionaire or simply to retire comfortably, free from financial worries.
How Exactly Does it Work?
The principle is simple: invest one pound for a year at an annual interest rate of, say, 10% and your money will be worth £1.10 at the end of the year. Continue to invest the £1.10 for another year, get the same 10% on the whole amount and you’ll end up with £1.21 after two years. The first year earned you only £0.10, but the second generated £0.11.
So, having established the benefits of compound interest let’s see how it can help us in our everyday financial planning.
All of us have financial goals set into the future that we aspire towards, be it simply repaying the mortgage for more financial freedom, saving enough to ensure a financially secure retirement, or taking the holiday of a lifetime.
Here’s the primary principle with all of the above: the earlier you start, the more likely you are to achieve your goal.
What will Your Investment Strategy Be?
Let's look at a simple example of two starry-eyed young men – let’s call them Del and Rodney – both of whom aspired to become millionaires. Sensible Rodney decided to save his pennies and, from age 24 to 30, managed to invest £2,000 per year in a portfolio recommended by his financial advisers, Trigger & Co. His investments grew each year by 12% net, and, although he stopped saving after he reached age 30, he left the money invested where it continued to earn 12% each year until he retired at age 65. Del, on the other hand, carried on spending all his money for another 6 years before he too started to save the same £2,000, also earning 12% net per year through the good offices of Trigger & Co. However, Del was able to continue investing £2,000 per year until he retired at the same time as Rodney.
So, did either of them achieve their goal of making a million? In the end, both of them just about made it. The difference is that sensible Rodney, because he started early, had to invest only £12,000 (i.e., £2,000 for six years), while big-spender Del had to invest £72,000 (£2,000 for 36 years) or six times the amount that Rodney invested to get to the same point. Therefore, waiting for 6 years effectively cost Del £60,000.
“He who saves early, wins”, as Del might have said ruefully!
The lesson is that investing sooner rather than later can be at least as important as the actual amount invested over a lifetime. Therefore, to truly benefit from the magic of compounding, it's important to start investing – or repaying debt because the same principle applies in reverse – at the earliest possible date. The idea, prevalent among many people planning for their retirement, that what they do in their 20s and 30s doesn’t matter, is a fallacy. Always remember, due to the effect of compound interest or compounded returns, gains beget gains, which beget even larger gains. This is the true magic of compound interest.
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