Investor Essentials: The power of compound returns
Compound returns are one of the least well understood benefits of investing, but when harnessed over the long term they can make a huge difference in reaching your financial goals.
With compound returns, it’s less about how much you can afford to invest straight away, and more about for how long the money has to grow. Leaving your money invested for the longer term can also help you to ride out short-term market volatility. This is why it is recommended that those that can afford to invest do so for the longer term, for at least three years.
What is compounding?
The way compounding works on your investments is relatively simple. In the first year of investing, you may generate modest returns on your initial investment. Without withdrawing that money and leaving it invested, in the second year, you would have invested the capital plus those potential returns you may have got from year one. Imagine this being repeated over several years (though you are unlikely to get positive market returns every single year) and so you unleash the potential to generate further returns on the total. And so, it goes on, helping you to build a bigger pot.
As you can see from the illustrative examples in our article looking at how investing an extra £50 or £100 per month could accelerate you towards your goals, over multiple years of investing, this can have a profound impact.
The illustrative results were generated through our compound calculator, which is free to use via our website and may help you to get a better idea of the benefits of long-term investing. Our tool is an indicator of future performance designed in aid to decision making – it is not a guarantee.
Why patience is key to building compound returns
No investment is ever guaranteed; you can be subject to the ups and downs of markets and may get back less than your initial investment.
You may not achieve positive returns every year, though as we outline in our volatility explained article, the probability of losing money has historically fallen the longer you stay invested.
Patience is key to allowing compounding to work its magic over time, and if you stay invested over a longer-term you are giving your investments a better chance to make up for any short-term losses. In the longer term, the power of compounding can really make a big difference as any percentage returns being applied to your pot can continue to grow.
Getting into the investing habit
It can be a good idea to get yourself in the investing habit, for instance, setting up a Direct Debit or easy bank transfer to ensure you make consistent contributions over time.
If you commit to setting aside a sensible amount that you can afford to invest every month and make regular contributions, small amounts can soon add up and you can increase your contributions later, perhaps as your income grows.
Investing in a multi-asset portfolio of equities and bonds, at an appropriate risk level, via a tax-efficient stocks and shares ISA, Lifetime ISA or pension can be a relatively simple way of starting the investing habit.
A wealth manager such as Nutmeg can ensure your portfolio remains diversified (to spread investment risk and improve your chances of benefiting from potential investment returns) and rebalance your portfolio to ensure it remains in line with your preferred level of risk over the long-term.
Although a central facet of long-term investing, compounding is not the only concept that's important to understand when planning your financial future. Other articles in our Investor Essentials series cover topics such as diversification, volatility, and tax wrappers.
If you require more help in reaching your financial goals, consider booking a free call to speak to one of our experts who could help you make the most of your money.
Risk warning
As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future performance.