How compounding can help your returns

Legend has it that the physics genius, Albert Einstein, once described the mathematical rule of ‘compounding’ – a vital ingredient for successful, long-term saving and investing – as the ‘eighth wonder of the world’.

In this video, Clare Francis, Director of Savings and Investments, explains the basics of compounding and why you should try and harness its power for your investments.

Compound can turbocharge your returns – so long as you have plenty of time on your side.

If you invest £10,000 and it returns 2% income after the first year, you will see £200 added to your investment pot.

In the second year as well as earning returns on your original £10,000, you also earn on the £200 growth. Should the rate of return remain at 2%, your investment of £10,200 would grow by £204 of income the next year giving a total of £10,404.

In subsequent years, the same formula applies, meaning your money grows at a faster rate by leaving the income invested.

With our theoretical example of £10,000 saved, a person who withdrew their 2% each year would see just £2,000 added to their original balance after 10 years, compared to a compound investor that would have had nearly £2,190 added.

After 20 years, assuming the same growth, your original balance would rise to £14,859. That’s £859 more than if you had received returns only on your original sum.

£10,000 invested and earning returns of 2% a year⁽¹⁾

As long as you are patient and have plenty of time before you need to tap into your investments, you should benefit from the snowball effect of compound growth as the years roll by.

This principle applies to money held in bonds that pay annual interest, shares that pay dividends (the share of company profits distributed to investors), and funds that can pay either depending on what the fund is invested in.

Many companies pay dividends quarterly or half yearly which means that compounding can get to work more quickly. The majority of funds pay out twice each year.

Reinvest those returns rather than take them as income, and the growth will compound. This means you’ll see your money grow – as long as positive markets mean the income being earned continues over the long term.

Consider the mathematical Rule of 72 as a rough guide to how compounding can work for you. Divide 72 by your selected annual income rate to get the number of years it should take to double your money. In our example, 72 divided by 2 equals 36 years.

Our figures don’t take into account the impact of markets on the original £10,000 invested which will hopefully also be rising over the years, though this is not guaranteed and it could fall in value.

The compounding sums in our illustration do not reflect the impact of inflation – the rising cost of living over time, which reduces the spending power of your money. Nor do they take account of any tax you might owe on returns or costs you may need to pay for holding your investment.

Further, when it comes to dividends, those companies that pay dividends may cut, delay or even cease them in economically challenging periods.

But by compounding the returns over the longer term you can potentially help your money work harder without lifting a finger.

By investing in a fund and selecting to buy accumulation units (rather than income units), the growth will compound without you having to do anything. The earlier you start saving and investing, the sooner you could start to earn interest or dividends (so long as companies pay them) and start seeing compounding work for you.