It is impossible to ignore the fact that the UK is currently going through a cost of living crisis. Inflation has skyrocketed to levels not seen since the 1970s and you’ve likely felt the effect on your personal finances.
Many people will feel that saving or investing is not an option in this current climate. However, over time, economies will re-balance and the skies will clear. When the time comes to get back on track with your financial goals, I’d encourage you to adopt the motto of saving early and often. This approach will allow your assets to work for you due to the wonders of compound interest, a mathematical formula which was allegedly described by Albert Einstein as the “eighth wonder of the world”.
What is compound interest?
To put it simply, compound interest is when you earn interest on both the capital you have saved and the interest you have already received. It allows money to grow exponentially over time and can help savers to turn small capital sums into large cash piles over many years.
For example, if I were to deposit £10,000 in a bank account for 10 years with an annual interest rate of 2.5%, I would receive:
- £250 interest income in the first year
- £256.25 interest income in the second year
- £312.22 interest income in the tenth year
My total cash pot would now be worth £12,800.85 (just over £300 more than if I only earned the interest each year on my initial capital).
Compound returns on long-term investments
Long term investors are one of the major beneficiaries of compounding investment returns. By investing small amounts over a long time horizon, compounding returns behave similarly to a snowball rolling downhill, starting off very small at the top and getting larger and larger over time as the snowball rolls down the hill.
For example: if a family invests £3,000 a year (approximately £250 per month) for their newborn daughter into a diversified equity portfolio, they will have invested circa £75,000 by the time she is 25. If this portfolio achieves a 5% annual growth rate over this period and all dividends are reinvested, she will also have received just over £75,000 from accrued investment returns. At age 25, she will have £150,340.
Compound returns and your pension
The chart below shows the incredible power of compounding returns in relation to retirement savings.
If you were to invest (net) £5,000 a year into a diversified portfolio with a 5% annual growth rate into your pension from 20 years of age, you would have a portfolio of £838,426 if you were to retire at age 65.
Alternatively, if you were to wait until you are 35 to save into your pension on the same growth rates and with the same retirement date in mind, you would have a retirement pot of just £348,804. Start at 45 and your retirement pot would be down at £173,596.
In fact, even if you were to double your savings to £10,000 per year and start at 45 you would still have a marginally lower pot than someone saving £5,000 a year and starting at 35.
The number of years invested is crucial to get the most benefit from long-term compounding. You may have missed the opportunity to start in your early twenties but, hopefully, you are convinced to save even just small monthly amounts as early as you can.
Please note that the investment examples used do not take into account the impact of inflation, interest rate fluctuations, taxes or any other ancillary costs of investing, they are simply to give a basic understanding of compounding and the benefits of investing early and often. Investment returns are not guaranteed and past performance is no guide to future performance.
Cash and inflation
At the time of writing (7thJuly 2022) inflation was sitting at 9.1% - the highest it has been for over 40 years. It is important to be aware of the negative impact higher inflation can have on the purchasing power of your cash deposits over time.
The chart below shows that, if you have £100,000 in the bank earning no interest, and inflation is at the Government’s target of 2%, then after 20 years you have already lost 33% of your capital in ‘real’ purchasing power terms.
If inflation were to remain at the current rate of 9% for the next 20 years, then you will have lost almost half of your purchasing power in 8 years and almost 85% over 20 years.
Whilst it is extremely unlikely that inflation will hold at 9%, it could easily trend higher than the Government’s 2% target for many years to come.
In this environment, savers must ensure that they keep their capital working as hard as possible, either by proactively moving cash into accounts with higher rates of interest (bearing in mind the FSCS £85,000 protection limit) or by investing funds over the longer term into well-diversified portfolios to benefit from long term compounding.
In the current period of stock market volatility and falling equity markets, drip-feeding (or pound cost averaging) new cash into the stock market on a regular basis gives you the advantage of being able to buy investments at a lower price than they were yesterday. Stock markets certainly won’t keep falling into perpetuity and there will come a time when you are buying into a rising market, however, this strategy also helps to take the emotional process out of investing by trying to time the market.
Is it time to discuss your financial future?
Hopefully, this insight into the wonders of compound interest and compounding returns makes you excited to start saving or investing for your long-term goals. If you have any further questions, or if you’d like to arrange a meeting to discuss planning for the future, please do get in touch.
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