Compounding: what is it and why is it important?

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Personal Investing

03 August 2020

Why, we believe, compounding is an essential part of the investor’s toolkit.

Whether you are thinking of saving for a big-ticket item such as a house or trying to get together a few savings for a rainy day, you’ve probably been told that the sooner you start saving, the better. Generally, the more time you give yourself to save, the better your chances of achieving those all-important personal goals … big or small.

The reason why, we believe, time is so beneficial to savers, is not simply due to the increased regularity of, for example, your regular wages, or any other regular income you may receive, but because you are allowing your savings more time to grow.

By way of example, let us suppose you invest £100 and, for that investment, you receive annual interest of 5% (remember this is for illustrative purposes only). All things being equal, the amount you will receive at the end of your first year is £105. Hardly life changing. But £5, nevertheless.

Example one. First year of saving – interest withdrawn after end of year one.

Now look at what happens in the example below. Rather than withdrawing the interest made on your initial investment at the end of each year, you reinvest it. By reinvesting the proceeds, you are, in effect, gaining interest on your interest. This is where we see the principle of compounding at work.

Example two. Annual interest reinvested year, after year, after year...

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In example two, the £105 you hold at the end of year one would not grow to £110 after year two as you might think (£105 +£5) but rather £110.25. That’s because the reinvested £5 gain from year one has generated £0.25 of interest in its own right. Remember, you’re getting interest on your interest.

Projecting this further out into the future, and assuming a theoretical constant annual interest rate of 5%, the same initial investment of £100 would grow to almost £128 after five years (see diagram). (While we would need more space to show the exact calculation here, if the same calculation were applied, with 5% interest reinvested on the initial sum of £100, after 15 years, the total amount would be £207.89).

Of course, we know that in the real world, even with interest rates at historic lows (and sadly not at 5%) they can, and do, fluctuate. As a result, the amount you receive on your initial investment may vary significantly from year to year and you may not get back as much as that which you had initially invested. That said, the concept of reinvesting interest on your investments is a powerful tool, with the length of the period (time) reinforcing this principle. So, while the best time to get started with your savings may have been a very long time ago, in our view the second-best time is to start saving today.

Remember, the value of any investment is not guaranteed. The value of investments and any income received from can go down as well as up and you may not get back as much as you had originally invested. There is no guarantee that any forecasts made will come to pass. Examples 1 and 2 have been provided for illustrative purposes only.