Compound interest has been described as the eighth wonder of the world. Understanding its effects is essential to success in investment, yet it remains a mystery for many people.
We are talking about returns where the gains are added to the capital sum, to which each successive period’s rate of return is applied.
The simplest illustration of this is to ask how long it takes to double your capital at 10% per annum compound return.
The answer is only seven years. However, it only takes a compound return of 7% per annum to double your money in ten years.
Let’s try another one.
Starting with £1,000, what do you think is the difference in the final capital from 30 years of investment at 10% per annum compounded, versus 30 years at 12.5% a year?
The answer, perhaps surprisingly, is that the extra 2.5% of compound return would double the final sum, so £1,000 invested would become £34,243 at 12.5% return as opposed to £17,449 at 10% return.
I ask this because it may represent a reasonable range of outcomes from an investment lifetime in which a person saves for 30 years before retiring, then tries to live on the income from the investments.
Compounding and its effects are quite difficult for us to understand. Maybe our minds are not built to handle such absurdities.
Investment legend Warren Buffett has seen $81.5bn of his current $84.5bn net worth accumulate after his 65th birthday. However, none of the 2,000 investment books about this guru are called ‘This Guy Has Been Investing Consistently for Three-Quarters of a Century’. It doesn’t have quite the same ring and appeal as overnight success. But we all know that this is the key to his success – maybe in a world that is ever changing, we need to take a leaf out of his book.
So, now that you have an idea of compounding, let’s try you with one last question.
Would you prefer to receive £10,000 cash now, or 1 penny which doubled in value each day for a month?
If you went for £10,000, then well done. You are £10,000 better off than when you started. However, for those of you who chose the penn,y then you would now be over £10.7 million better off than the person who chose the £10,000. But at Day 10, you would only have had £5.12, and at day 20 £5,242.88 – it was the last 10 days that would have made you into a multi-millionaire!
If you would like to find out how to take advantage of compounding within your portfolio, then please contact us, and we will be happy to explain it to you. We can’t guarantee that you will be the next Warren Buffett, but you will understand how your portfolio grows over time.
