Albert Einstein called this the 8th wonder of the world, and there is good reason for this, because once you understand the miraculous power of compounding you will become much more in tune with disciplined investing (I hope!!).
So how does it all work?
Take your bank account, and assume that you are earning 5% interest per year (now that would be miraculous). If you had £100 saved in that account you could expect to receive £5 interest at the end of the year giving a total of £105. You could spend that £5 and only have £100 left in the bank, no more or less.
However, let’s assume you keep the £105 in the bank for another year, at the end of next year you won’t have £110 but £110.25. A small, insignificant amount I know, but you have just earnt interest on top of interest, and this will make a huge difference over time.
Let’s increase the amounts and time to see the power take its full effect. Assume now we save £250 per month for 10 years earning 5% per year.
After 10 years, investing £30,000 in total, our balance is £38,748.
After 20 years, investing £60,000 in total, our balance is £101,864 – Another £30,000 invested has given us an additional £63,116 return.
After 30 years, investing £90,000 in total, our balance is £204,672 – Another £30,000 invested has given us an additional £102,808 return.
Hopefully, you can see that time is your friend on the journey to wealth creation, and those early years investing make the difference. That’s why I’m always keen to start small but start early, and that you keep on increasing your savings throughout life as your income increases. Think of a snowball starting off at the top of a mountain, initially as a single snowflake. Hardly powerful or mighty, but with time that snowflake amasses into a small ball of snow, gathering more pace as it slides down the mountain, gathering momentum and mass, until that snowflake has turned in a huge wall of snow causing destruction as it increases in speed and size.
Now if you combine the miracle of compounding with asset classes that provide both income and capital appreciation, you have arrived on the super highway of creating wealth. Unfortunately, savings into cash only help increase your balance through the interest payment being received. With real assets like equities (The Great Companies of the World) and property, you have the possibility of rising capital value and income.
Making a profit
If you buy a share in a company, and that company makes a profit, you receive a dividend (an income payment from the profits). If you then use the dividend to buy more shares, the value of your holdings will increase. Also, the capital value of the shares would hopefully rise over time, so your dividend allows you to buy more shares whilst the value of those shares increases also. Don’t forget that the price of equities can be volatile in the short term. However, as long term investors looking at decades of investing in the Great Companies we have little to fear as we are disciplined and wise!
Total investment returns
This double bubble, of dividend income and rising capital value is what is known as Total Return, and it’s how your investments can be super charged to increase over time. The power of Total Return is why the majority achieve their wealth through investments as opposed to leaving their money in the bank.
So to recap: Harness the power of compounding through saving early and regularly.
Past performance is not a reliable indicator of future performance.
This guide is for information purposes and does not constitute financial advice, which should be based on your individual circumstances.
The value of investments may go down as well as up and you may get back less than you invest.