What Is Compound Interest?

It's the most powerful aspect of investing.

Albert Einstein is reputed to have said, “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn't, pays it." Compound interest is extremely powerful but it can be quite complicated to understand on first glance so I’ll try to keep it as simple as possible. Essentially the key is to add money to your investment on a regular basis and/or re-invest capital gains/dividends.

Passive Investor

Let’s say you start off with a £5000 deposit into a conservative ETF returning 10% a year. You then deposit £200 a month over 10 years (the below figures don't take into account inflation) This is what you end up with after 10 years Total deposits: £24,000 Final Investment Value: £53,260 If you keep it running for 20 years you end up with: Total deposits: £48,000 Final Investment Value: £178,434

Over 40 years: Total deposits: £96,000 Final Investment: £1,345,217 Yes, thats over a million pounds with a total of just £96,000 invested. Incredible isn't it? Clearly you can see the exponential growth the longer you keep the investment running. Now there are other ways to compound in the stock market even as an active trader which aren't discussed often . You can choose not to add more money and let the general growth of your portfolio do the compounding for you, it will work as per the example below.

Active Trader: Let’s say you start out with £1000 in your account and made a 20% gain over the year. Your total return will be £1200 for that year. And let’s say your usual stake in any company is 5%, this would equate to a £50 trade on a £1000 account. With the 20% gain your account is now worth £1200 and the 5% stake on any future trade would now be £60. If you make 20% again over the next year your account is now worth £1440 and the 5% stake on any future trade is now worth £72. You can see how the money makes money. In year one you made £200, year 2 would be £240, year 3 would be £288. You should also re-invest any dividend payments to enhance this growth. Bare in mind this is based on consistent growth and ignoring any significant drawdowns, 20% returns per year are no mean feat. You should always increase your investment size along with the growth of your portfolio, therefore compounding returns. Ideally you want to add more money as and when you can to any investment, since inception in 1926 the S&P500 has returned on average 10% a year, this is fairly conservative target that even the average investor can achieve with a few carefully selected funds. There are more volatile ETF’s that can return far greater percentages but with bigger gains come bigger risks. So to sum up compounding/compound interest is just as important as stock selection. If you keep taking out any profits to waste on cars, nights out etc your account will never grow. Don’t hesitate to start investing, the best time to start was 20 years ago the second best time to start is today. Test out the compound interest calculator today and see how much you can return: https://www.thecalculatorsite.com/finance/calculators/compoundinterestcalculator.php

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