Q. Why is compounding so important?
A: Aiming for high returns every year is not key to long term big capital gains, compounding is – to put this into perspective due to the power of compounding, if you start with £10,000 and grow it at 100% per year you end up with £1 million in less than 7 years. Shares magazine narrates an example where £44,000 invested today in UK shares and held for the next 30 years, with dividends reinvested, could turn into £1,000,000. Even taking into account that this is in nominal as opposed to real terms (and ignoring the effects of inflation), it is still an impressive figure and should attract anyone’s attention. This calculation assumes FTSE All-Share’s 7.4% annual growth rate since its inception in 1962, plus an average 3.8% dividend yield for a total yearly 11.2% return.
Below you can see the power of compounding at work – this starting with with £10,000 and growing at 100% per year.
| Example showing the Power of Compounding [Starting Capital – £10,000] | ||||
| Annual Growth Rate | 100% | |||
| Year 1 | £10,000 | |||
| Year 2 | £20,000 | |||
| Year 3 | £40,000 | |||
| Year 4 | £80,000 | |||
| Year 5 | £160,000 | |||
| Year 6 | £320,000 | |||
| Year 7 | £640,000 | |||
| Year 8 | £1280,000 | |||
Compounding – the earlier you start the better!
So compounding is important to magnify returns – but not only that, starting early (!) makes a big difference as well. Take the below example of two investors who start investing – one at age 25 and the other at age 33 with their portfolios making average annual gains of 10%:
Investor A starts saving for retirement at age 25. For eight consecutive years, Investor A saves €2,000 per annum and his investment makes a theoretical annual income of 10%. After eight years, Investor A makes no more contributions but lets his money compound year after year. Investor B only starts saving at age 33 (this is the age when Investor A had finished contributing to his savings plan). Then Investor B continues consistently to contribute €2,000 every year until the age of 65 (generating the same annual return of 10%).
Who do you think will realise the larger investment sum? These are incredible results. Although Investor A has invested only €16,000 in total compared to €66,000 by Investor B, A ends up with more money than B because of the power of compounding.
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Compound Interest – the earlier you start the better!
