Investor sentiment is dropping lower every day in the face of war and inflation. Given this, it seems the right time to discuss the magic of ‘compound interest’. Albert Einstein (allegedly) described it as the “eighth wonder of the world”. And while it is a simple concept, we need a reminder of the power of exponential growth every now and again.
Financial education provision is patchy in the UK, with only around a quarter of adults being functionally numerate according to the National Numeracy charity. This, perhaps, goes some way to explaining our poor saving and investing rates – surely if more people understood the power of compound interest, they would be putting it into practice.
But the idea is simple to get your head around. Vanguard senior financial planner Zoe Dagless uses an annual return of 6 per cent in an example in a recent paper focused on young investors. Dagless said that an investor who saves £262 each month from the age of 25 would have an investment pot of over £500,000 by the time they hit 65 (this doesn’t take into account platform fees or potential additional tax relief). The crucial point here is that around £375,000 of the final pot comes from capital growth – this is the power of compounding.
And we can see clearly the benefits of starting to invest early. The same investor would have to save £514 a month from the age of 35 or over £1,100 a month from the age of 45 if they wanted to achieve the same final pot, Dagless said. This is pivotal for young investors to understand.
That, at least, is the idea. But there are of course no guarantees in investing – Goldman Sachs warned last year of a “lost decade” for returns from traditionally weighted portfolios. With surging inflation, rising interest rates, and globalisation going into reverse, structural factors that have driven up equity prices in the last decade are under threat. According to Vanguard, the FTSE All-World index has posted an average annual return of 9.9 per cent since 1993 – this is unlikely to be repeated over the coming years.
History is not always guaranteed to repeat itself, but the precedent is clear. J. Stern & Co chief investment officer Christopher Rossbach pointed to analysis from the asset manager that shows that “even if we are facing headwinds … even if we suffer a couple of years of volatile stock market performance … if our holding period is five years or more, then the chances that we won’t make a positive return are almost next to none”. Keep investing over the long-term and benefit from the magic of compound interest.
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