How compounding can help your returns

4 minute read

Einstein called compounding the Eighth Wonder of the World.  Find out how the formula can work wonders on savings and investments.

The value of investments can fall as well as rise and you could get back less than you invest. If you’re not sure about investing, seek independent advice. Tax rules can change and their effects on you will depend on your individual circumstances.

What you’ll learn:

  • How compound growth works
  • How long term investors can benefit
  • An example of compounding in action – in pounds and pence.

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.

One of the main long-term benefits of investing is the impact of compounding.

Albert Einstein once described compounding as the eighth wonder of the world.

But what does it mean and why’s it so powerful?

Well, effectively, compounding is when you earn returns on your returns.

So the longer you invest, the more you can potentially benefit.

Say you invest £10,000 and after the first year it’s gone up in value by 5% and is now worth £10,500.

If it grows by another 5% in the second year, that’ll be 5% of £10,500, not just the original £10,000, so by the end of year two your investment would be worth £11,025, and so on.

Over time, compounding can have a significant impact on overall investment returns.

It’s a bit like a snowball rolling down a hill.

It starts small but then gets bigger and bigger.

You benefit from the effect of compounding with cash savings too because of the interest you earn.

However the effect tends to be greater with investments because you not only reap the reward if share prices go up and the value of your investments rise, but you can also reinvest any dividends you receive which helps turbo charge things further.

Here’s an example in pounds and pence.

If you invest £5,000 each year from the age of 18 and assume it grows by 5% a year, it would be worth over £700,000 by the time you reach 60.

But if you wait until you’re 30 to start you’d only have about £350,000 by the time you hit 60.

This is why investing is so-well suited to long-term financial goals.

The idea is to get invested, and stay invested.

It’s all about time in the market, not timing the market.

So the sooner you start the better, because you’re giving your money more time to grow and longer to benefit from the magic of compounding.

How compounding works

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.

How your pot might snowball
£10,000 invested and earning returns of 2% a year1
End of year Value of investment with compounding (£) Value of investment without compounding (£)
1 10,200 10,200
2 10,404 10,400
3 10,612 10,600
4 10,824 10,800
5 11,040 11,000
10 12,190 12,000
15 13,459 13,000
20 14,859 14,000

The power of compounding

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.

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