What is compound interest?

• Compound interest is, in essence, the interest on interest.
• If you make 10% on an initial deposit – say £100 – 2 years in a row, your total increase is not 20%. Rather it is 1.1 x 1.1, which is equal to 21%. This is because in the second year, the 10% increase is applied to the new amount of money – £110. The 10% interest in year 2 applies to the  £10 earned in year 1.
• This is not just significant – it is the single mathematical principle that underlies the basis of investing.

Albert Einstein allegedly wrote that ‘compound interest is the 8th wonder of the world, he who understands it, earns it; he who doesn’t, pays it’. It’s not clear if he actually said this, but I can’t say I disagree!

Why?

The purpose of investing is to turn an initial deposit of money into a larger one. The longer you invest your money, the more money you should make. But because of compound interest, the gains made on the initial deposit will increase exponentially, that is to say at an increasing rate.

If you invest for 20 years, rather than say 5, the increase you will make on your initial deposit will be proportionally far higher.

Let’s use the example of 10% a year again. If you invest for 5 years, the total increase will be (1.1)^5, which is 61%. But for 20 years, the total increase is 573%. This is a staggering difference.

To put this in context, an initial investment of £100 would be worth £161 after 5 years. Say you took the £61 as a profit and invested the £100 again for 5 years. After 20 years of this pattern you would have made a profit of £244. Now; if you had just left the money for 20 years, you would have made a profit of £573. Thats a difference of £329 or an increase of 135%.

How does this affect me?

The conclusion from these experiments is simple: the longer you invest, the greater your returns will be.

My takeaway is as follows – the earlier you can start investing, the better.

In my opinion, too many people start investing too late. Apart from a pension, many people only really start to invest if they have a considerable sum of money. This could be well into their 40s, 50s or 60s.

The issue with this is simple. If they had started investing – even just a small sum of money – in their early 20s, they’d already have a considerable sum of money by the time they were older!

Whatever your financial goals were, this would surely help them. Whether that is to be richer, or just to retire earlier. I’m not sure a super-car would make me happy (in fairness I can’t even drive), but being able to play golf all day surely would – although no change from university there!

An experiment

How much can you reasonably make from compound interest then?

It’s not obvious what a reasonable amount of annual interest is. However, many people like to use FTSE 100 as a benchmark. To get a figure for a reasonable expected interest rate, I will therefore use the annualised return of FTSE 100. This is 7.75% a year since its inception in 1984.

Let’s say you had £10,000. Due to the magic of compound interest, if all you did was leave it in a FTSE 100, theoretically after 40 years, that sum would be worth nearly £200,000.

However, more realistically, you would be adding to that sum each year. Let’s say that you were able to put aside £500 a month for this purpose. After just 20 years, you would have made interest in excess of £200k. After 40 years, total interest of £1.74 million. Certainly not bad for total deposits of £250k – retirement would be very comfortable on this amount.

While it’s likely not reasonable to have £10k in savings at 18 years old, nor be able to put away £500 a month in the early years of your career, compound interest still demonstrates the value of doing so (should that money be available). I will write an article soon on how saving early means you can retire early.

A very silly experiment

This year, I had an exceptionally fortunate year investing and made interest of 34%. This would be very difficult to replicate yearly. However, much like the initial deposit, the greater interest you can earn, the more that interest compounds.

Now, using the same figures at previously (10k initial deposit, £500 monthly payments), how much interest could I make after 20 years if I could keep making 34%?

£10.5 million.

After 40 years:

£3.73 billion (that would be a ‘comfortable’ retirement)

After 60 years:

£1.3 trillion

So there you have it. If I could just make 34% a year, by the time I was 80, I could well be the world’s richest man. I think spending that much would be a far greater challenge than earning it though.

To do your own interest rate calculations, I found this tool very useful.