Most people know what compound interest is. But many investors may not fully appreciate how much difference compound interest can make to the performance of their investments.
Compound interest is a great friend to investors and it’s also the reason why long-term investing is such a great way to build wealth.
In this video, I explain why compound interest can make a big difference to the performance of your investments. I also look at three investment lessons that follow on from the power of compound interest.
• See all MoneyWeek videos here.
• To download Ed's videos to your mobile device via iTunes, click here.
• Get all of Ed's latest video tutorials sent straight to your inbox every week - sign up FREE to MoneyWeek Videos here.
Hi, in this video, I'm going to look at the power of compound interest and how it's a really useful weapon in the armoury of nearly all successful investors.
And then following on from that, I'm going to look at three other useful investment lessons that are linked to the power of compound interest. So, let's have a look at what compound interest actually is. Let's say you've got £1,000. You stick it in a bank account and you're getting interest of 10% a year. I know that's way higher than what you get now, but it's good for the example.
So, we're getting £1,000, 10% after a year. That £1,000 has grown to £1,100 – our cash gain is £100. In the second year, £1,100 has grown to £1,210. So, our cash gain now is bigger – it's £110. And that's because we're getting interest on the capital, but also interest on the interest. And it goes on like this.
When we get to year four, our £1,000 has grown to £1,464. And that's because we're getting interest on the original capital, but we're also getting interest on the interest and interest on the interest on the interest. And interest here as well. We're getting all this interest compounding up, growing, and giving us the power of compound interest.
And if we kept this money in the bank account for many more years, growing at 10% a year, the cash gains that you'd make each year would snowball up, and you'd start to build a really sizable savings pot. Obviously, this doesn't just apply to savings, it also applies to investing as well.
So, let's imagine you've got £1,000 which you're going to invest. If you want to use the power of compound interest to get a really good return, it makes since to start investing young. So, if we start young, we've got £1,000 and we're getting 5% a year annual gain, that's on top of inflation. So, it's a better return than it sounds.
After ten years of having that money in the stock market, we'd have £1,628 – a cash gain of just over £600. If we then leave the money in the stock market for another ten years, after 20 years, our money's grown to £2,653, the cash gain is over £1,000.
And remember we're getting still a 5% gain a year on top of inflation. That's actually turning into quite a good return on our money. If we stay in there for 30 years, our money grows now to £4,300, our cash gain is well over £1,600.
We can only start to get these sort of snowballing investment gains if we can stay invested for a long time. And obviously, if you can start investing younger, you're more likely to get that kind of long-running snowball. I wasn't investing when I was 25. I wish I had been. I suspect most people watching this video are over 25 too, but if you know some younger people, tell them to find any spare cash they can and start investing then and benefit from compound interest.
Now, one crucial point though – getting this kind of 5% return above inflation. If you're going to get that kind of return or, indeed, a better return, you're almost certainly going to have to reinvest your dividends from the shares you invested. Academic studies have shown that around two-thirds of the long-term return from stock markets comes from dividends, not from growing share prices.
So, let's look at a really long term example here. Let's imagine you put £100 into a UK index tracker fund in 1945. I know, there were no tracker funds then, but you get the idea. Put £100 into the stock market in 1945 and leave it there until 2010 – very long time horizon, but it makes the point.
If you didn't reinvest the dividends over the 65-year period, your £100 would turn into £255. Now, again, that's a real gain – it's on top of inflation. It's okay, but it's nothing special – nothing to get excited about.
But if you reinvested your dividends over that 65-year period, your £100 would turn into £4,370. It's a vastly better return all because you reinvested your dividends. So, if you've got money in the stock market, if you possibly can, reinvest. Let the power of compound interest really kick in and deliver some great investment gains.
My final point is that just small changes in the annual return can make big differences over the long term. When we looked at these figures, we were assuming an annual 5% return on top of inflation. And that, after 30 years, our £1,000 has become £4,300.
Well let's imagine instead of a 5%, we had a 6% annual return. Suddenly, that £4,300 would be £5,743, just because you were getting one extra percent a year.
So, it really pays to identify the investments that will deliver you the best return without taking too much risk over a long period. And it also pays to keep the cost down because that's another way just to bump up the annual return by one or may two percent, just getting the costs down.
So, that's three lessons we've learned following on from the power of compound interest. Small differences in return make a big difference. Reinvest your dividends and start young. And that's the best way to utilise the power of compound interest.
I hope you found this video useful. I'll be back with another one soon.
Until next week, good luck with your investing.
A note about our free emails, advertising, and how to unsubscribe.