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One of the key reasons it’s so important to invest earlier and more frequently is because of something called compound interest.
What is compound interest?
To put it simply, compound interest is when you earn interest on both the capital you have invested and the interest you have already received. It allows money to grow exponentially over time and can help savers and investors to turn small capital sums into large cash piles over many years. Referring to it as one of the greatest “miracles” known to man, Albert Einstein described compound interest as “the most powerful force in the universe”.
But it was perhaps Benjamin Franklin who best captured the meaning and value of compound interest when he defined it as “Money makes money. And the money that money makes, makes money.”
People as successful as American business magnate Warren Buffet have attributed their wealth to “coming from a combination of living in America, some lucky genes and compound interest”. We can’t count on the first two attributes to help us become a billionaire, but all of us can take advantage of the extra wealth that compound interest can offer.
The snowball effect
We all know what happens when you push a small snowball down a hill. It continuously picks up snow and becomes a gigantic snowball when it reaches the bottom of the hill. The snowball effect is an analogy for compounding. It explains how small actions can lead to big gains over time.
Compounding is perhaps easiest to explain in terms of typical cash savings accounts paying interest, but the impact of inflation on cash savings, as we will highlight later in this article, erodes the purchasing power of your money.
For example, if you were to deposit £100,000 in a bank account for 10 years with an annual interest rate of 4.0%, you’d receive:
Your total cash pot after 10 years would now be worth £148,024.43.
Playing the long game
You won’t see the benefits of compound interest overnight – it takes time to build and suits a conservative, long-term investing approach.
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 interest doesn’t always work in your favour
When you borrow money you’ll be at the mercy of compound interest working against you. Just watching the balance barely move after making a payment on a high interest credit card balance puts this in stark perspective. Albert Einstein captured this issue perfectly in his famous quote “Compound interest is the eighth wonder of the world. He who understands it earns it, he who doesn't, pays it."
I have other financial priorities now – if I can invest more later in life will my savings and investments catch up?
The key to optimising the benefit of compound interest is to avoid the temptation to put off saving. The earlier and more you can save the better. 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.
It’s never too late to benefit from compounding
The number of years invested is a key factor in maximising the benefit from long-term compounding, but as our earning capacity typically increases as we get older, it’s never too late to benefit from your money growing exponentially, but you may need to invest more to compensate for starting later in life.
The power of long-term investing v cash savings
As interest rates on cash savings are invariably lower than the rate of inflation, it’s still likely, even with compound interest, that the purchasing power of your wealth is being eroded.
If you have spare cash or income you don’t need right now, then investing it offers greater potential to protect your money from inflation. Taking a long-term view, a diversified portfolio of assets that are actively managed and give broad exposure to different global markets and industry sectors can provide the potential for inflation-beating returns.
You may have missed the opportunity to start in your early twenties or thirties but, hopefully this article will help inspire you to invest consistently and as early as possible to help you build towards a secure financial future.
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Bespoke portfolio management
At Investec Wealth & Investment (UK), we believe your financial future should be in the hands of qualified investment professionals. Our award-winning bespoke discretionary managed portfolios are highly flexible, giving you access to a range of innovative and market-leading services built around your personal preferences and specific investment goals.
We have a team dedicated to supporting people like you. Please get in touch to discuss your financial needs today.
The value of investments and the income derived from them can go down as well as up and you could get back less than you originally invested. Your capital is at risk.
This article does not offer advice and the content and information about potential investments and services are designed for general use, and so cannot be considered personal to your circumstances or your financial position.
Investec Wealth & Investment (UK) is a trading name of Investec Wealth & Investment Limited which is a subsidiary of Rathbones Group Plc. Investec Wealth & Investment Limited is authorised and regulated by the Financial Conduct Authority and is registered in England. Registered No. 2122340. Registered Office: 30 Gresham Street. London. EC2V 7QN.