Compounding explained

There is a famous Gary Larson cartoon. Great moments in science: Einstein discovers that time is actually money.

This was of course a joke – but it actually contains a grain of truth. The man behind the theory of relativity may not have discovered compound interest, but in reality, he was sufficiently impressed by its effects to call it the ‘eighth wonder of the world’.

What is compound interest?

Compound interest, or compounding, is a basic principle of investment. It means that when you invest, as well as earning interest on the initial amount, you will also earn interest on the interest it earns.

This means that not only is your initial investment increasing over time, but the amount it earns potentially increases as well.

So, if you invest £100 at 10%, at the end of your first year you will have £110. With simple interest, at the end of the second year, you will have earned another £10, giving you £120. With compound interest, however, you will have earned 10% of £110, giving you £121.

The difference is just £1, which sounds trivial. However, if you allow sufficient time, that difference will add up to a much larger return, because every year, you will be earning interest on more money.

In this example, at the end of 10 years, simple interest will earn you £100, giving you a total of £200. Compound interest over the same period would mean a total in your pot of around £255.

Calculations are a little difficult, but you don’t need to be an Einstein to see that you are considerably better off thanks to compound interest. There are plenty of online calculators which will let you see the phenomenon in action for yourself, and if you are sufficiently proficient you can even create projections in an Excel spreadsheet.

Getting compounding working for you

Understanding the exponential growth created by compounding is essential to make the most of your investments. Compounding is a key factor in any effective wealth creation strategy – you need to ensure that it is working for you.

Given the potential benefits, this is easier to achieve than you might expect. You simply need to follow two guiding principles. The first is to ensure that all the interest earned by your investment is reinvested, and the second is to leave everything invested for as long as possible.

Time really is money. With compounding, the more time your money is invested, the more of it you will potentially have.

The benefits from staying invested for as long as possible don’t stop there. In the real world, with real investments, interest rates on savings and returns on investments will go up and down with the markets and the economy in general. This means that over time, your compounded returns will also go up and down. You might even see a fall in some years – but overall, the returns on investment should be positive, and your funds will have the best chance to grow.

Staying invested for as long as you can will mean that you stand a better chance of rising out the troughs and benefitting from the peaks in the market. It should also help you experience more growth to mitigate the negative, wealth-eroding result of time - inflation.

What should you do?

To benefit from compounding, the simple answer is to start as soon as you can, because the longer you invest for, the more time and thus potential for compounding to grow your wealth.

Of course, you will want to make sure that your wealth is invested wisely. You don’t want to take any unnecessary risk with your long-term investments.

Deciding on your investment plans merits getting some expert advice. Of course, you can call on our experts at Continuum to provide it.

The information contained in this article is based on the opinion of Continuum and does not constitute financial advice or a recommendation to suitable investment strategy, you should seek independent financial advice before embarking on any course of action.

The value of investments can fall as well as rise and you may get back less than you invested.

Equity investments do not afford the same capital security as deposit accounts.