Investing Basics: compound interest
Compound interest is the eighth wonder of the world. He, who understands it, earns it … he who doesn’t … pays it.’ Albert Einstein
How different could things have been if only we’d known about the power of compound interest in our callow youth? – writes Christian Leeming
If only we’d known then that the most important factor in a successful investment strategy was its duration, then we’d have done things differently wouldn’t we? One less Watney’s Party Seven and a few more entries in that Building Society book.
Those new to DIY investing, pondering the road toward their financial objectives may call to mind the punch line to a joke that was definitely of its time – ‘well Sir, I wouldn’t start from here’.
And however tough we thought we had it, spare a thought for those recent graduates, trying to make their way in the world with the burden of student debt, astronomically high accommodation costs and constantly reminded that they will be facing abject poverty when they retire unless they set aside the large chunk of their salary that they could well do with to pay their extortionate utility bills.
It’s tough, but whether you are planning for your own financial future or looking to give a loved one a head start, compound interest comes as close as is possible to ‘money for nothing’ – and you can only start from where you are.
How Compound Interest Works
Compound interest is the multiplier effect of interest being earned on interest, over time; the higher the interest rate and the longer the period of saving or investment the greater the end result.
For example a saver putting £100 into an account paying 5% interest would have a balance of £105 at the end of the year; 5% interest on £105 adds £5.25 in year 2 and so on:
Year Principal Interest Total
@ 5%
1 £100 £5 £105
2 £105 £5.25 £110.25
3 £110.25 £5.51 £115.76
10 £155.13 £7.76 £162.89
If interest had been added only to the principal sum a ten year investment at 5% would have yielded just £50 whereas compounding ‘miraculously’ yielded almost £163.
OK, so that may not be a game changer, but what if you add to that original savings pot by an additional £100 per year, and you build a portfolio of investments that delivers 10% per annum in a tax efficient environment. Then things look a little different:
Year Principal Additional Interest Total
Investment @10%
1 £100 £100 £20 £220
2 £220 £100 £32 £352
3 £352 £100 £45 £497
10 £1730 £100 £183 £2012
By maintaining an additional investment of £100 per annum, certainly things start to look a little more interesting and as amounts increase and time horizons are extended, compound interest can make a dramatic difference to your financial outcomes.
Time is the key to generating such momentum – in the above example £1,000 is invested in £100 tranches over a ten year period; however, if this sum had been invested in a lump sum at the outset, compound interest would have turned that into £2593.74 – not to be sniffed at and all the more delicious if it’s sheltered from HMRC in a tax efficient wrapper.
'there are currently believed to be 200 ISA millionaires in the UK’
The Telegraph recently reported that there are currently more than 1,000 ISA millionaires in the UK – one Hargreaves Lansdown customer has even topped £2 million – and this number is set to swell to more than 2,000 as savvy DIY investors take advantage of low platform fees and generous annual investment allowances.
If the current ISA annual subscription limit of £20,000 rises in line with inflation, an investor achieving 5% return per annum and paying around 1.1% in charges could achieve a £1 million pot in 27 years and 10 months – around £500,000 profit on £500,000 investment.
Compound Interest in Action
To highlight the differences, let’s consider the potential outcomes that could be achieved by a steady and disciplined investor, who we’re going to call James, and a rather more profligate cove named Jeremy.
James invests £2,000 per year into an ISA from the age of twenty five until other calls on his money mean that he stops investing at age thirty five and he never adds to his pot again.
James then leaves his investment untouched to grow until his meticulously planned retirement; achieving an average return of 7% over the 40 years of his investment means that James’ fund is worth £225,073 by the time he reaches for his niblick.
On the other hand, Jeremy spent much of his hard-earned cash in his twenties on fast cars, wine, women and song; some he even wasted, so he came late to the savings and investment party but when he did latch on, he did so with gusto, tucking away £2,000 per year for each of the thirty years following his thirty-fifth birthday bash.
Jeremy achieved the same 7% average return on his investments, but despite having invested three times as much as James – £60,000 against £20,000 – the value of his pot at stumps was just £202,146 – around 11% less.
On the grounds that you can only start from where you are, the DIY investor should grasp the nettle and work out what an investment regime needs to look like to enable you to achieve your personal goals.
‘the DIY investor can hope to do significantly better than the savings rates to be found on the High Street’
When faced with the prospect of setting an unrealistic proportion of salary aside because of coming late to retirement planning, many simply do nothing, and that can never be the right decision; something is better than nothing and sooner is always better than later.
If we revisit the example above, by year ten the annual interest earned is greater than the initial investment and by year thirty the results can be truly stellar.
Year Principal Additional Interest @ 10% Total
Investments
1 £100 £100 £20 £220
30 £17935.71 £100 £1803.57 £19839.28
‘Twenty grand for just an extra hundred quid a year?!’ Well, that takes us back to the risk/reward curve, which is probably for another day; it’s not impossible to achieve 10% annual returns, but to do so over such a long period of time would be to achieve consistently better results from the stock market than the majority of the professionals do. Those with disclaimers ringing in their ears may set more modest objectives.
However, that is not to say that with some judicious planning and diversification the DIY investor can hope to do significantly better than the savings rates to be found on the High Street
ISA millionaires do the basics of DIY investing consummately well; they invest for the long term without trying to time the market, they get as much money in as they can as early as possible and leave it there for as long as they can, whilst keeping fees to a minimum.
In terms of their choices of investments a Motley Fool investigation found that ISA millionaires tend to keep a small proportion of their assets in cash as an emergency fund; they invest in individual stocks, but always in pursuit of dividends and long term capital growth rather than punting; typically these most successful of DIY investors will invest just under half of their pot in collectives, where the Fool found that investment trusts were almost always chosen above unit trusts.
This time in 25 years Rodney….
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