Compounding is the process of generating more return on your money by earning interest from an asset's reinvested earnings. It works like a snowball effect which continues to accumulate more and more.
Compounding works by reinvesting your profits at every opportunity. For compounding to work you need to reinvestment your earnings and you need time.
Compound interest can help your initial investment grow beyond your wildest expectations and it is best to start investing at the earliest age when considering compound interest. This is because the longer your investment is compounded the more returns you will gain.
Compound interest isn't just an angel, it can also be a devil in disguise. How? Well the same way compound interest can add more to your bottom line by reinvesting your earnings ...it can also add more to your debt by compounding your debt.
This means interest owed on your debt will be added to the debt and more interest will be charged to the combined interest + debt. This process goes on until you repay the debt in full.
For this reason you must always know the interest structure on the financial products you enter into. This will at least prepare you for any eventuality.
Below are two real world examples of compound interest at work.
Example #1: Apple stock🍎
An investment of £10,000 in the stock of Apple (AAPL) that was made on December 31, 1980 would have grown to £2,709,248( Wait...what… Yes, you read right!) as of the market’s close on February 28, 2017.
This translates to an annual return of 16.75%, including the reinvestment of all dividends from the stock.
Apple started paying dividends in 2012. Even so, if those dividends hadn’t been reinvested the ending balance of this investment would have been £2,247,949 or 83% of the amount that you would have had by reinvesting.
While Apple is one of the most successful companies, and their stock is a winner year-in and year-out, compound interest also works for index funds, which are managed to replicate the performance of a major market index such as the FTSE 100.
Example #2: Vanguard 500 Index📰
Another example of the benefits of compounding is the popular Vanguard 500 Index fund.
A £10,000 investment into the fund made on February 28, 1997 would have grown to a value of £42,650 at the end of the 20-year period. This assumes the reinvestment of all fund distributions for dividends, interest or capital gains back into the fund.
Without reinvesting the distributions, the value of the initial £10,000 investment would have grown to £29,548 or 69% of the amount with reinvestment.
In this and the Apple example, current year taxes would have been due on any fund distributions or stock dividends if the investment was held in a taxable account, but for most investors, these earnings can grow tax-free with the use of your personal ISA allowance (currently £20,000 for 2017/2018 year) and in tax free ISA account such as the stocks and shares ISA.
Getting your ducks in a row early🦆🦆🦆
Compound investing is a strong tool, as a matter of fact. It is probably the strongest investment tool out there to generate long term wealth.
You need such little money to get started that not getting started with compound investing will definitely have some opportunity cost for you.
Cutting down on night outs once a week could save you £6,000 for the year. That's £6,000 you could put away to generate compound interest over 20 years.
To generate a million pounds in 35 years you will simply need to invest £880.21 a month and get a constant return of 5%.
I know, I know...finding £880 seems like a hill climb… I know, you have other priorities etc etc.
If you cant increase your income, your can at least try to reduce your expenses. Plug your accounts in your Huuti dashboard to see how much we can save you on your loans, credit cards and household bills.
Compound interest might be the safest path to retirement savings. Start now. Open a pension account. Do anything but put some money away and reinvest the earnings.