Read any article about compound interest and it’s likely to start with a reference to Einstein calling it the “Eighth wonder of the world”.
Like most pithy quotes from Einstein, he probably never said it.
Here’s a real quote from Einstein:
“In the temple of science are many mansions, and various indeed are they that dwell therein and the motives that have led them thither.”
So you can see why people make them up.
But compounding is pretty nifty, not to mention a vital part of investing.
To understand it, first you need to get to grips with non-compound or simple interest.
Simple interest is paid as a fixed percentage of the original amount of money you lend or invest (AKA the principal ).
Here’s a simple example.
If you lent £100 to your friend at 10% simple daily interest, they’d owe you £10/day, for as long as the loan remained unpaid. If they paid you back after 7 days, the final bill would £170.
Looking at investments, this is also the kind of interest paid on fixed income or bonds, where the interest payment (coupon rate) is usually a fixed percentage of the face value.
This is much more… interesting.
With compound interest, interest is paid on the original sum plus the past interest. It’s basically interest on interest. With debts, this can make a big difference.
Take that generous £100 loan. If you were wily (and didn’t care about losing friends), you could charge 10% interest, but compounding daily.
“Hahahah… I want my money, Karen”
Each day of the loan, the interest would be calculated as a percentage of the original money and all the past interest so far.
After day one, they’d owe £110, the same as with simple interest. But after day two, they’d be charged 10% of £110, to bring the total to £121.
After 7 days, your friend’s total bill would be £194. Plus dry-cleaning costs after they throw their coffee at you.
Compounding really comes into its own with investing returns. That’s because returns on your initial money you invest can then grow themselves. With the help of time, compounding growth can turn a modest initial portfolio into a sizeable hoard.
Compounding means you have a very good chance of outperforming Warren Buffett over the next 40 years. Why?
Well without being harsh, it’s because you’ll almost certainly outlive him. Especially if he keeps eating ice cream for breakfast.
To take a dramatic example, let’s say you manage a solid but not spectacular 5% annual return on a £10,000. Assuming you keep your gains invested here’s what you’d make over the years.
This makes a lot of sense when you think about it. After all, when you invest, you’re taking an ownership stake in real companies. And if a company grows 5 years in a row, each year it’s growing from a better position than the last.
You can check out our compound return calculator to have a look at potential returns on your portfolio. You can duplicate the sheet to do your own calculations. Just plug in the annual return you’re targeting, the initial money you’ll invest and the money you’ll add to your portfolio per year.
Bear in mind that, much like an inept darts player, you may not hit your target. You can also use our calculator to look at the same performance with a broker who charges fees.
Compound return of the same portfolio with a free Freetrade account vs a broker charging 0.45%/year
Compound interest combined with time can be very powerful. According to one study, ten years of actively adding money to your portfolio followed by 30 years of passive compounding outstrips 30 years of actively adding money and growing at the same rate.
Having 40 years of compounded growth would be better than 30, even if you kept adding more money each year in the second scenario.
So what does this mean for me?
The longer you’re investing, the more years you have to grow. If you do want to start building a portfolio, the earlier you start, the more time you have to compound.
If you procrastinate with your investments, you don’t just miss out on potential returns, you also miss out on the returns of those returns. And then the returns of those returns, until you’re stuck in a spiral of opportunity cost and general annoyance.
Time is pretty much the only finite resource you have as an investor — no-one’s getting any younger. Apart from Hugh Jackman.
80 years young