“Compound interest is the eighth wonder of the world. He who understands it earns it… he who doesn’t… pays it.” Albert Einstein.
Compounding is one of the most important principles behind wealth creation and successful long-term investing. But, as Einstein suggests, it can become a cost to bear for those who don’t understand it.
Below we explore how compounding can either build or erode your wealth.
Consistent actions have the greatest impact on our outcomes
The results of our actions compound over time to create our outcomes.
We all understand that a once-in-a-blue-moon visit to the gym, while regularly consuming take-aways, won’t make us fit and healthy. Similarly, an occasional clean of our teeth does not make for good dental hygiene.
Our direction of travel is very much determined by what we do consistently.
It’s the same with investing. Compounding is the process of drip-feeding money into your investments, regularly and consistently over a long period of time, and leaving them there to grow.
Your money can work hard for you while you sleep
Once invested, your money earns interest or a dividend (known as “yield”), which can be reinvested to buy more units of the investment, increasing the amount you have to earn the yield on in the future.
Effectively you are earning a yield on your yield. This is compounding.
The diagram below demonstrates how compounding can work on a £100 investment with an assumed 5% annual yield.
In year one you can see the increase generated by the 5% yield, which seems small to start with. However, over 20 years, the sum you have invested has increased in value to over 2.5 times the £100 you originally started with. Your money has been working hard for you, with your effort limited to making the initial investment and leaving it there.
The next step is to compound the impact of this by investing on a regular basis. Putting away an amount you can afford and feel comfortable with, month after month, leaving it invested for the long term is the key.
Over time you will create a significant nest egg.
Over a 20-year period with a 5% yield, just 60% of the pot you end up with is money you had to contribute yourself. The other 40% is the result of compounding.
Set yourself up to succeed with good habits – pay yourself first
One way to create a good habit for your saving and investing is to pay yourself before you pay anyone else. Upon receipt of your regular income, set up an automatic payment to your investment or savings account. Then forget about it.
Moving the money out of your current account, means that you’re far less likely to see it as cash available for you to spend.
The benefits of financial planning itself compound and accumulate over time
As with all our actions, the benefits of sound financial planning also compound over time.
Every cost and tax saving made is money that you retain for the benefit of you and your family in the future. Invested money is money that’s left to work hard for you, so continues to benefit from further compounding.
The effect of each good decision builds over time.
Each tax saving you made over the years, each additional or larger pension contribution, investing in lower cost investment solutions, and having the confidence to take some or more investment risk now you better understand it – are all decisions that compound over the years, resulting in greater wealth for you.
There are also other savings good financial planning delivers, meaning that good financial planning can more than pay for itself.
The interest and fees you’re paying can compound to erode your wealth
Unfortunately, used in the wrong way, compounding can be very destructive. The simplest way to explain this is to look at the impact of credit card interest on an outstanding balance. If you pay 20% interest a year on the balance, in year two you’re paying interest on the interest you accumulated in year one. And so on, year on year… paying interest on interest, with the debt increasing.
The fees you pay for your investment management are being deducted from your investment pot, compounding over time to erode your long-term wealth.
While no-one can predict future investment returns, we can all control the costs we pay. At Life Matters we recommend market-leading but low-cost investment solutions to ensure as much money as possible is retained in clients’ investments, compounding to build their wealth.
Remember, every pound you spend on costs is a pound that’s no longer invested to work hard for you. Of course, avoiding expensive interest on credit cards will also leave far more in your pocket in the long term.
Compounding is an important principle for young savers and investors to understand. The earlier they start saving, the less money and effort they’ll need to accumulate wealth in the future.
If you would like to have a conversation about how you’re benefiting from compounding and if there’s more you can do to avoid the pitfalls, please get in touch. Email us at your@lifemattersfp.flywheelstaging.com or call 01202 025481.
Please note, the value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.