It’s said that Albert Einstein dubbed ‘compounding’ as the eighth wonder of the world. While it may be a term you’re not overly familiar with, compounding has the potential to significantly affect your wealth, for better and for worse.
This is why the importance of understanding how it works and the opportunities and threats it presents to your money cannot be overstated. Read on to discover all you need to know about compounding, and why it has the potential to be your financial best friend or worst enemy.
Compounding is growth you make on growth you’ve already made
When you invest your money you’re exposing it to growth potential. This could be accelerated with compounding, as any growth your money enjoys is then exposed to further growth potential in the future.
To demonstrate this, you might want to consider the following example. If you use a compound growth calculator, you will see that if you invested £100,000 and achieve an average growth of 3% every year, you could have around £103,000 at the end of the first year.
If you leave it invested, the growth in the following year will be based on £103,000, meaning it could then grow to £106,175 at the end of year two. Indeed, if you remain invested for 10 years, your initial investment could be worth nearly £135,000 due to compound interest.
By comparison, if you had received 3% simple interest, you would have received £3,000 every year that would have returned £30,000 in total. Compounding has therefore boosted your returns by an additional £4,935.
After 20 years, the effect of compounding means that the growth on a £100,000 investment could be worth more than £82,000 – a £22,000 boost to your money’s performance.
The longer you invest for, the greater the potential for compound growth
As you can see from the above example, the longer you leave your investment exposed to compound growth the greater the growth potential. With this in mind, if you’re considering investing in a Stocks and Shares ISA, a pension or other stock market investment, the sooner you start the better.
This might be particularly true if you want to make monthly contributions to an investment, as opposed to larger, one-off lump sums. This is highlighted in an article by This is Money, which was published in February 2024 and makes for interesting reading.
It highlights research that found that if you invested £250 a month and had an average return of 5% a year, after 10 years the investment growth delivered by the power of compounding would be 30% of the overall portfolio.
If you remained invested for 20 years however, it would be 72%. Please remember that this is only for illustrative purposes and does not consider the effects of inflation. You should also bear in mind that investing carries risks, and you may receive back less than you originally invested.
Compounding can be a threat as well as an opportunity for your wealth
While all of the above is broadly positive, there is a major downside to compounding: if it forms part of the interest charged on a debt, the amount you owe could spiral in a short space of time.
In the same way that growth is boosted by compounding, the interest you pay on debt can be too. This could be dangerous, especially if the interest rate being charged is high.
This is because any amount owing will have interest charged on it, and if you are unable to pay the full amount off, interest is charged on the outstanding balance. The following month, interest is again charged on the amount you owe, which also includes the interest accrued the month before.
In the same way that you could enjoy additional growth on your investments, the lender is increasing the amount of your debt through compounding. This could be why Einstein also said “he who understands [compounding] earns money, and he who doesn’t, pays it”.
Get in touch
As you can see, compounding could make a significant interest to your overall wealth over the long-term. If you would like to discuss how investing could expose your money to compound growth, and whether it’s right for you, please call us on 01527 577775 or speak to one of our advisers. We would be happy to help.
Monday 25 March 2024