So how does compounding work?
Let’s say you bought £10,000 worth of shares in a company and in the first year they increased in value by 20%. Those shares are now worth £12,000, giving you a £2,000 return. In year two the company did well, and the value of your shares increased by another 20%. Your shares are now worth £14,400, an increase of £2,400 in year two. The extra £400 was earnings on the first year’s earnings.
Can compound interest make you rich?
Yes, it can. There are three key factors which can dictate the extent of compounding on your investment. The first and possibly the most obvious is that your initial investment must stay where it is. The second is the rate of return on your investment. In the above example our investment made a very healthy (and possibly a little unrealistic) 20% return each year. The third is the length of time you leave your money to grow.
If the original £10,000 was left for 10 years, at a constant rate of 20% it would grow to £61,917. If the same sum was left for 30 years at the same rate of return, you’d end up with a cool £2,373,763. That’s the amazing effect of compounding. The table below demonstrates this using a range of returns over different periods.
The downside of compounding that many investors ignore.
The reality is that most people will only look at the return on their particular investment. What many won’t even know is what fees they are paying for the privilege of holding those investments. Annual management charges (AMC), total expense ratios (TER) and ongoing charge figures (OCF) are examples of fees and charges that can also be affected by compounding. Let’s take the above table and adjust for a portfolio of funds where the annual charges are 1.5%. Let’s also add in inflation at a rate of 5%.
That’s a pretty depressing set of figures. The corrosive effect of fees and inflation can have a devastating effect on the value of your investments over time but it’s a detail that too few people pay attention to.
Compounding can have a very powerful and positive effect on your investments but beware the small print. What might seem like small fees are potentially robbing you of your wealth, not to mention the ever-present effect of inflation. Arm yourself with the knowledge and understand how to make compounding work for you rather than against you.
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