It has been called magic and a miracle. It is of course neither of those, but compounding, or compound interest, is a concept that every investor should appreciate.
In effect, compound interest is the interest that you earn on your interest. When investing, it means generating further returns on reinvested earnings – things like dividends. To take advantage, an investor must reinvest any earnings from his or her investments and leave them to earn further returns over time.
Let’s look at a simple example of how compounding works.
Let’s say you save or invest £1000 and you achieve a return of 5% a year. In year one, your £1000 earns £50. You keep that in your savings or investment pot. In year two, your pot of £1050 earns £52.50. Again, you leave the interest in your pot. In year three, your pot is now £1102.50 and you earn £55.13 of interest. By the end of year five, your pot is worth £1276.29 and you have earned £276.29 in interest.
By leaving the interest or investment earnings in your pot, it is generating more interest itself. Now let’s look at the impact over time.
Let’s say you invest £10,000 and manage to achieve a return of 10% a year, or £1000. You could take that £1000 each year and use it as income. Each year your £10,000 earns the same £1000. After ten years, you have earned £10,000 from your £10,000 investment. Not bad at all.
But let’s look at what would have happened if you’d reinvested the return each year. In year one, you earn the same £1000 return. But you leave it in your investment pot. In year two, you earn 10% of £11,000, in year three 10% of 12,100 etc. After ten years you have earned a return of £15,939 – that’s nearly £6000 more than if you’d taken the return out as income each year.
That’s the power of compounding at work. It’s no wonder it has been described as magic. By letting your investment returns earn returns of their own, you could be adding tens or even hundreds of thousands of pounds to your investment pot over time.