If you mention compound interest to me I will automatically think of the traumatic experience I had at middle school trying to calculate it with pen and paper. Nevertheless, even I appreciate its unofficial title as “eighth wonder of the world” (the words of Albert Einstein, reportedly).
A quick refresher: compound interest is when small amounts of money grow into large sums over time because interest is reinvested.
Understanding the concept of it is easy enough; getting a real sense of the financial impact it can have on your savings is imperative. In fact, the majority of people underestimate its power, which can lead to poorer long-term financial decisions like a failure to save.
A survey from Orbis Investments earlier this year, for instance, found just how unintuitive the concept can be. In a hypothetical scenario, more than three-quarters underestimated the correct amount of compound interest a plan would earn. Fewer than 7% estimated within the correct range.
The question asked was: You invest £100 on a child’s behalf into the stock market via a Junior ISA. Without using a calculator, what is your best estimate of what the investment would be worth on the child’s 18th birthday if the stock market generates an average annual return of 8%?
The mean estimate was £246. The correct amount was £400. I decided to revisit my trauma of calculating compound interest with slightly more modern tools in an effort to visualise this impact.
Make Money Work Again
Just like Orbis, we’re starting with £100 in our imaginary investment portfolio, and we’re not adding any other funding. After one year, that money would grow to £105 with a 5% interest rate, and £120 with an interest rate of 20%. Easy enough, and not a lot to write home about.
But as we saw with the junior ISA, the real power is in long-term growth. If you happen to be as successful as Warren Buffett’s Berkshire Hathaway, which has had an annualised growth of 20% for however many years, you could be looking at turning £100 into £23,738 over 30 years. This, of course, is miles away from a compounding 5% over 30 years, which turns into £432 – but even this is a quadrupling without ever touching the money or adding anything to it.
As you can see, if you want to accumulate wealth, starting early and focusing on the best possible return can make a significant difference.
So what if we want to add extra money our investment portfolio? The below table shows how our savings would accumulate if we started with the same £100 but added an extra £100 at the end of every year.
The 5% return over 30 years suddenly jumps from £432 to £7,076. And the 20% investment portfolio? From £23,738 to £141,926. That said, most of us will probably see returns in the middle somewhere. And with inflation, it might only just be enough to keep the money at the same value.
Identify Quality Stocks
When we last wrote about compound interest, my colleague Jocelyn Jovene made two important observations. Just being invested is not good enough, as most of us have probably realised in this market downturn (any dodgy growth stock bets? Yeah, me neither).
Getting into the more comfortable bracket of the compound interest matrix requires careful study of key elements: the price you pay for the assets in which you invest, their intrinsic qualities and their value. The same, of course, goes for funds, trusts and ETFs. Do you trust your fund manager to pick these assets for you? What is their track record?
For instance, if you want to invest your money in stocks, you will need to select high quality that are currently trading at a cheap valuation. A high-quality company will have a strong competitive position in its market, operate in a growing industry, generate high return on capital, a growing free cashflow, maintain a strong balance sheet, and have a competent management.
To Jovene’s second point, however: you can’t control the market. Equally, you can’t control a company’s valuation, which usually reflects other people’s opinion of the company. But, if you’re patient enough, and know which assets you want to buy, you just have to bide your time and wait for the market to provide an opportunity to buy something you like at a fair price.
But like Buffett says: time in the market beats timing the market, every time. Compound interest is the proof.
