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Investing for beginners: Compound interest and its enemies

Investing lessons are in session

Though it might not always feel like it, you have one big advantage over City fund managers.

True, they have the training, best research, computers and analysts.

But they’re also judged daily by their bosses and their clients, and woe betide any manager who starts to lag their peers or the market. A mere 6-12 months behind the pack can be uncomfortable. Underperforming for a couple of years or more can be deadly.

A desire to keep their well-paid jobs and be seen to do something – plus an overdose of self-confidence – means some fund managers trade shares almost like gambling chips at Las Vegas in their pursuit of short-term profits.

These fund managers are smart, but the short-term is unpredictable and trading is expensive. Overall this tactic typically hurts their long-term returns.

Other managers avoid getting fired by covertly tracking the index, guaranteeing they don’t lag too much in any given year. The resultant returns are mediocre, yet these closet index funds still charge their investors high active management fees, instead of the rock bottom charges of a true tracker fund.

While this might seem less harmful than actively trading and doing worse than the index, even apparently modest fees add up over the years.

The tortoise that beats the hare

You’re playing a different game to City fund managers. Nobody is watching your month-to-month performance, except maybe yourself.

You can think long-term when it comes to your goals, and how to get there.

And with a longer time horizon, you can turn to the most powerful investing tool of all: Compound interest.

Compound interest is the interest earned on interest, over time.

Think of compound interest like a snowball set rolling from the top of a hill.

When it starts its journey, it may only be the size of a football. But as it rolls down the hill it accumulates more snow.

Soon it’s the size of a beach ball.

As the snowball gets bigger, the area onto which new snow can stick gets larger.

This means that halfway down the mountain and the size of a car, the snowball is adding a far greater volume of snow per revolution than it did at the top, even though the percentage rate of growth is unchanged.

It’s the same with compound interest.

Let’s say you invest £1,000 and you earn interest of 10% a year:

Year Capital Interest earned at 10% New total
1 £1,000 £100 £1,100
2 £1,100 £110 £1,210
3 £1,210 £121 £1,331

Note: The 10% rate was chosen simply for easy maths!

In the first year you earn £100 in interest. But after just three years, you’re earning £121 a year.

That’s 20% more added to your savings in year three than in year one – all without contributing any extra money beyond that initial £1,000.

  • After ten years you’d be adding £259 a year.
  • After 20 years you’d be adding £672 a year.

A few more years again and you’d be earning as much in interest in a year from your savings pot as you first invested1.

All without putting in an extra penny!

Compound interest and long term saving

Let’s consider two investors: Captain Sensible and Captain Blithe.

From the age of 25, Captain Sensible invests £2,000 per year in an ISA for 10 years until he is 35. At 35 he stops and never puts another penny in.

Captain Sensible then leaves his nest egg untouched to grow until he hits 65.

Let’s say Captain Sensible earns an annual return of 8% from age 25. When he looks at his account 30 years later, he has amassed £314,870.

In contrast, his cousin, Captain Blithe, spends all his money between the ages of 25 to 35. Only when he hits 35 does Blithe start tucking away £2,000 per year in his ISA. However he keeps this up for the next 30 years until he reaches 65.

Captain Blithe earns an average annual return of 8% on his money, too. But he ends up with just £244,691.

 To recap…

  •  Captain Sensible invested a total of £20,000.
  •  Captain Blithe invested a total of £60,000.

… yet early-starting Captain Sensible’s pile is worth 28% more than late-starting Captain Blithe’s – even though Sensible only invested a third as much money as Blithe!

That’s the glory of compound interest.

Returning to returns

What’s that I hear you say?

“Good luck getting 8% a year in interest for 20 years!”

Quite right. Nobody is going to guarantee you that rate of return for two decades.

This is where the blended asset allocation that we saw in Lesson Four comes in.

UK equities have returned on average 8-10% a year2. Smaller companies, unloved shares, and emerging markets have generally done even better.

However all equities are volatile.

Young investors saving a lot of money every year might choose to ride out the volatility by investing 100% in equities for a shot at the very best returns. But they are taking a risk – and there are no rewards without real risks.

Older investors have less time to benefit from compounding as well as fewer years in which to add new money to the markets.

So as we age, it makes sense to increase our weighting of less risky assets, in case the stock market crashes in the years before we retire and we need the money.

The ideal long-term portfolio will therefore contain a lot of volatile assets like shares early on in its life, but a greater proportion of safer assets like cash and bonds in the later years, when we have less time to recover from stock market crashes.

The enemies of compound interest

Viewed through a prism of 30 years of compounded returns, short-term results gained from one month to the next – or even one year to the next – fade away.

What’s important is that we maximise our returns for the level of risk we’re prepared to take.

If you genuinely can trade shares better than the market, or you can profitably time the shift of your money between one asset class and the other, then trying to ‘play the markets’ will boost your returns.

But most people can’t, or at least not consistently. They will effectively buy expensive and sell cheap, cutting their returns.

What’s more, all this activity reduces your returns in other ways.

Dealing isn’t free, and there are other trading costs, too. If you use a fund manager, she might charge you 1.5% a year. All these costs reduce your returns.

Remember that due to compound interest, small changes in the rate of return make a big difference to your final payout.

For example:

  • £10,000 compounded at 8% for 30 years is around £100,000.
  •  The same amount compounded at 6% is less than £58,000.

Knowing about compound interest doesn’t just tell you why you should own at least some shares with the hope of earning 8-10% on average a year, over multiple decades – even though your share allocation will lurch up and down in value compared to the cash you save in a bank account.

Compound interest also shows you why you really need to keep costs and taxes low, in order to avoid sapping those returns and ending up with much less than you might have expected.

Key takeaways

  • A sound investment strategy aims to secure a good annual return over the long-term, not pick the best thing to own in the next month.
  • Compounding a decent annual return every year can grow your wealth like a rolling snowball gathers ever more snow.
  •  Keeping costs low will make a big difference in the long-term.

This is one of an occasional series on investing for beginners. You can subscribe to get our articles emailed to you and you’ll never miss a lesson! Why not tell a friend to help them get started?

  1. I am ignoring the impact of inflation here, which would reduce the worth of that money in real terms. []
  2. Without adjusting for inflation. The exact average return figure varies depending on who is counting and over what time period. []

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{ 13 comments… add one }
  • 1 Calm Investor May 29, 2014, 10:41 am

    Great article! Compounding as a concept is easily the most powerful and the least appreciated concept in investing. I try to illustrate this by showing how 17% return a year for 5 years doubles what you started with.

    Also posted about the power of compounding here: http://thecalminvestor.com/investing-powerful-force-compounding/

  • 2 The Rhino May 29, 2014, 12:02 pm

    you can use the old 72 / % return to work out approx time to double.. quite handy

  • 3 MrsFinancialFreedom May 29, 2014, 12:05 pm

    The trouble with compound interest is at first, when your investment stash is low, you don’t really see that much of a benefit from it. But when your investment stash starts getting bigger and bigger, then you really see the effect compound interest can have. Unfortunately, I’m still at the stage were I’m not seeing much benefit from it!

  • 4 Qpop May 29, 2014, 12:17 pm

    This is great and I (a keen mid-twenties investor) am sending it to all of my friends.

    It would be much better to give inflation adjusted figures, though. I know nice big numbers illustrate the point so much better, but what use is £340,000 if a loaf of bread costs £30?

  • 5 ermine May 29, 2014, 3:45 pm

    I think you should, however, also point out that 10% is an unrealistically high annual compounding rate, particularly in real terms. Half that is doing very well indeed. All of a sudden the difference between Captain Blithe and Sensible drop away somewhat. Captain Sensible saved money earlier in his working life, when his earning power is less. If he uses pensions, he is more likely to be a HRT taxpayer later on and will get a massive win from that

    Put it this way, I used your very own compound interest calculator to work out what would have happened had the young ermine saved 5% of my gross inflation-adjusted starting salary for 10 years and then stopped, leaving it for another 20 years. It’s a piddling amount compared the amount I managed to save in AVCs in a desperate 3 years saving everything I could, and that’s just my pension savings, it excludes filling ISAs those years and hitting up NS&I for as much as I could.

    The compound interest story is lovely. But the fact that you need to sex it up to make it interesting is telling. It’s a lot less lovely at realistic real rates of compounding. Or alternatively, and realistic lengths of a working life – if we worked for 60 years then maybe that young-un’s contributions might make that big an impact when the old man logs out for the last time.

    It is indeed because the long term gains from stock market investing is in the 5% ballpark that the difference between fees of 1% and 0.2% matters – the former is as much a swing at your income as HMRC on wage-slaves. If the realistic rate of return really were 10% that would be less of an issue. It’s notable that the FCA won’t even allow pension companies to show the optimistic equity rate of return as high as 10%!

  • 6 helfordpirate May 29, 2014, 4:34 pm

    No beginners’ article on compound interest is complete without the famous Einstein quote:
    “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”!
    I don’t recall whether Albert was a passive or active investor though.

  • 7 The Investor May 29, 2014, 5:14 pm

    @Ermine — Well, I said under the table that the 10% was chosen purely for ease of maths. Indeed (no offence! 😉 ) your comment is only just scraping through my “this is for beginners” filter.

    People suggest all these things should get added to an entry-level article like this, but what they’re saying is “complicate it”.

    Anyway, I didn’t say 10% returns. I said 8-10% returns, nominal. I happen to believe that isn’t completely unrealistic for an aggressive young investor using cheap passive funds and investing across the asset classes, with sensible tilts towards value, small cap, and emerging markets.

    See this table I previously cited from Mebane Faber: http://monevator.monevator.netdna-cdn.com/wp-content/uploads/2013/08/lazy-portfolio-returns-data.jpg

    Around 10% CAGR nominal from a whole variety of different asset allocations.

    Yes that’s US data, but then again those portfolios generally didn’t have much international and/or emerging market exposure.

    As I’ve written before, I don’t buy the “we’re doomed to 1-3% real returns” mantra (and here I disagree with The Accumulator, incidentally). I think your 5% average real should be easily achievable for someone with sufficient equity exposure from a young age, though no guarantees.

    I think your maths/rationale is suspect, too. Somebody shouldn’t save just 5% of their salary from say 20 for ten years and then stop, and then expect it to compare favourably at 50 (your example — i.e. 30 years later) to the massive savings possible by someone in their 50s who has gone into fire-fighting mode and is saving 50% or whatever. (And who is also using tax advantaged savings (AVCs in your case) which you don’t allow the 5%-er in the same maths. Foul! 😉 ).

    Compound interest does what people say it does, it doesn’t have live up magical claims for it. The “10 years and stop” scenario is to show how it compares to saving later, not to claim it beats any arbitrary savings scheme you want to compare it with, as you have here.

    A realistic figure to use for a long-term savings plan for somebody who doesn’t want to eat beans in a panic in their 50s is 10% of gross salary (much less being actually lost if they use a low-cost self-directed pension, as you know).

    Somebody on £30,000 saving 10% of their income from 25 to 65 will end up with £380,000 at a 5% real interest rate, in today’s money. That’s not bad.

    I am ignoring the fact that it would actually cost them less in tax-adjusted terms and/or that they could contribute more for the same loss of spending power with SIPPs etc.

    I am also ignoring the fact that nearly everyone reading this site and saving 10% of their salary (i.e. some sort of educated worker) will likely see their real-terms salary climb much higher over their lifetime. Maybe not as much as in the 1950-80s, but I’d imagine it’ll have doubled by the end (or they’re doing something wrong!)

    Here I’m simply assuming they keep the contribution rate fixed at 10%, or £3,000 in today’s money. To further ward off panicky baked bean eating in their 50s, it’d be sensible to increase it in line with their salary. At this point their fund grows very nicely indeed.

    For example, using this calculator I see an annual real terms salary increase of 2% a year (sufficient to take that £30k to £66k in real terms, so say a teacher who eventually becomes a head teacher) will increase the fund to over £500,000, sticking to the same 10% rate (and continuing to ignore tax — when in reality under the current regime it would get cheaper and cheaper for our saver to pay for that 10% as they age).

    You’ve railed against compound interest before, for reasons I don’t understand. The maths is very simple and straightforward, *if* you compare apples with apples.

    People can take issue with saying a 25-year old can/will contribute 10% at say 25, but then most people couldn’t slash all their spending and outgoings and save like their lives depended on it in their 50s like you did. 🙂

    Nothing gets around the fact that saving for a comfortable retirement does take some sacrifice somewhere. But I’d rather let compound interest and time take the strain. 🙂

  • 8 The Investor May 29, 2014, 5:16 pm

    @Qpop — Thanks for sharing!

    @helfordpirate — The truth of the Einstein quote is disputed. 🙂

  • 9 OldPro May 29, 2014, 5:18 pm

    To TheInvestor, Bravo…!

  • 10 ivanopinion May 30, 2014, 9:09 am

    In relation to the time scales over which compounding applies, it does of course depend on what age you retire. Some retire at, say, 52; those who wait until, say, 70 have another 18 years of compounding.

    And it depends what you plan to do with your money when you retire. If you plan to buy an annuity or you need to pay off your mortgage, then compounding stops at that point. But if you live off your portfolio, compounding continues, albeit at a lower (or even negative) rate because you are spending some of your investment returns.

  • 11 The Rhino May 30, 2014, 9:44 am

    @ermine – i tend to agree with you, i think the compound interest story is over-egged – maybe an article on your site with a few scenarios mapped out with the accompanying no.s would provide the ying to this articles yang? (perhaps you’ve already written it?)

    whilst the maths of compound interest are non-refutable, its the ‘accumulation of marginal gains’ (in brailsfords terminology) from all the other nuances of saving over ones lifetime, you note a good few, that make compound interest, certainly for me, not the panacea it offers itself up to be at first glance.

  • 12 The Investor May 30, 2014, 9:58 am

    @All — In deference to this being a beginner’s article as discussed, can we draw a line under the compound interest conversation ‘right or wrong’ here please. It’s basically right, as far as I’m concerned, and beginner readers are better knowing about it and getting on with saving and taking advantage of it, as opposed to having second thoughts about saving and investing due to clever people dancing on pinheads in the comments. 🙂

    Ermine’s comment and my response are here to provide a bit of a second opinion. You can also follow the link I included in my reply to Ermine (follow the hyper-link under “you’ve railed”) to see Ermine’s wider discussion about its alleged cons.

    Cheers!

  • 13 Gerard June 28, 2014, 1:55 am

    I thought your choice of Captain Sensible as a name was neat neat neat.

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