Compounding has been coined as the ‘Eighth Wonder of the World’, attributed to Albert Einstein no less. Strong words, but compounding is a powerful concept and it’s not just about growing wealth; it’s about setting the foundation for long-term financial freedom.
This will sound geeky, but compounding is probably the most exciting aspect of investing, especially when you look at it in terms of the long game – your financial plan. It’s essentially the process where your initial investment earns returns, and then those returns are reinvested to earn even more. Over time, this cycle, compounding, can help build wealth substantially, which ultimately provides security and financial freedom.
Some figures will help to illustrate the true power of compounding. Imagine you invest £10,000 with an annual return of 5%. After the first year, you’ll have £10,500. Now, instead of taking that £500 gain out, you let it compound. The next year, you’re not just earning on your initial £10,000 but also on the £10,050, which brings you to £11,025.00. This process continues, and after 30 years, without adding any more money, your initial £10,000 investment would grow to £43,219.42.
Now, let’s consider if you added an additional £1,200 (which works out as £100 per month extra), to your investment every year. With the same annual return of 5%, after 30 years, you wouldn’t have £43,219.42, but a whopping £121,746.00. That works out as an increase of £78,526.62 for £34,800 of extra payments into the investment. That’s the real power of compounding at work!
The late, great investor Charlie Munger, wisely advised, “The first rule of compounding is never to interrupt it unnecessarily.” This is a golden rule for investors: the longer you allow your investments to compound, the greater the potential for growth. Of course there may be times were accessing funds, and therefore breaking the compounding cycle, is necessary. However good forward planning can help to alleviate the possibility of this happening to a degree (retaining a cash buffer, planning for future expenses such as a car purchase, having separate pots for education etc).
Warren Buffett, Charlie Mungers former business partner and one of the most successful investors of all time, has often highlighted the importance of compounding. He once remarked, “My life has been a product of compound interest.” A simple phrase which highlights the impact compounding has had on his wealth-building journey. Indeed, such has been the compounding success Buffett has had, he still remains in the top 10 richest men in the world, after having given away $55 Billion to charitable foundations.
Einstein said, “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it”. Remaining invested and not interrupting it (if possible) are the keys to understanding and earning it. Similarly, understanding that debt utilises the power of compounding, for the benefit of the lender, is important to remember. To ensure you don’t over-pay it means you basically have to interrupt the lenders compounding (by paying down debt a bit quicker if possible – as we have seen earlier – an extra £100 each month can make a massive difference in the grand scheme of financial planning.
Compounding is the patient investor’s best friend and, when understood, can be the cornerstone of a successful long-term investment strategy.
Start early, stay consistent, and watch as compounding turns your financial goals into reality.
To finish up here are some practical tips for anyone looking to harness the power of compounding in their investment journey:
- Start Early – The sooner you start investing, the more time your money has to compound. Even small amounts can grow significantly over time.
- Regular Investing – Make regular contributions to your investment portfolio, no matter how small. Consistent investing can have a big impact due to compounding and pound coast averaging.
- Reinvest Dividends – Instead of taking the dividends and income as cash, reinvest them. This increases the amount of money that is compounding.
- Be patient – Compounding requires time to work its magic. Resist the temptation to withdraw your investments early.
- Understand Interest Rates – Paying debt at higher interest rates can significantly reduce the amount of money you end up with – be it debts such as mortgages, personal loans, credit cards etc
- Utilise Tax-Advantaged Accounts – Make use of tax wrappers such as ISAs and pensions. These allow investments to grow tax-free or tax-deferred, enhancing the compounding effect.
- Monitor and Review – Keep an eye on your investments to ensure they are performing as expected, but avoid the urge to tinker too often. Review once a year with your financial planner!