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 [1].
A desire to keep their well-paid jobs and be seen to do something – plus an overdose of self-confidence [2] – 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 [3] still charge their investors high active management fees, instead of the rock bottom charges [4] 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 [5] 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 [6].
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 [7].
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 [8] that we saw in Lesson Four comes in.
UK equities have returned [9] on average 8-10% a year2 [10]. Smaller companies, unloved shares, and emerging markets have generally done even better [11].
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 [12].
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 [13], 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 [14] 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 [15] 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 [16] low, in order to avoid sapping those returns and ending up with much less than you might have expected.
Our compound interest calculator [17] enables you to quickly visualise the impact of compounding the returns on your investments.
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 [18]. You can subscribe [19] to get our articles emailed to you and you’ll never miss a lesson! Why not tell a friend [20] to help them get started?