The extraordinary power of compound returns

Whether saving or investing for your future goals, it’s important to start as soon as you can. That way, you’ll be better placed to maximise the benefits of ‘compounding’, known as compound returns. With compound returns, it’s less about how much you can afford to put aside, and more about for how long the money has time to grow.

What are compound returns?

Compound returns have been referred to as the eighth wonder of the world. They are also an investor’s best friend.

The basic concept is simple. In the first year of investing, you may generate returns on your initial investment. In the second year, you invest the capital (your initial investment) plus the returns, and you generate further returns on the total. And so it goes, with your money snowballing into a pot.

For example, if you’d invested £5,000 in the FTSE All Share in 1986 – and withdrawn any returns – it would have grown to £28,357 at the end of 2016. If you’d let your investment benefit from compounding (by ‘re-investing’ the returns), you would have had £88,396 for the same period¹.

Of course, investing is subject to the ups and downs of the stock market and there’s a risk you’ll lose some of the money you’ve put in, so returns aren’t guaranteed. However, by investing over a long timeframe, you give your investment time to make up for any losses.

If you’re depositing money into a savings account, your capital is safe (up to the FSCS protection limit) and the effects of compound interest are even more tangible. If you have £1,000 in a savings account that pays 5% you’ll earn £50 interest in the first year. In the second year, you’ll earn £52.50 interest even if you don’t put any more money in – and provided you don’t take any out, of course. In the third year, your money will generate interest of £55.13, and so on and so on. However, given the current economy of low interest rates and rising inflation, you’re unlikely to find a savings account offering an interest rate of 5%.

Underestimating the power of compounding

There have been many studies into compound returns and why we fail to mentally account for them properly. One such study was conducted by Craig McKenzie and Michael Liersch at the University of California².

They asked groups of undergraduate students to consider how much their money would grow if they deposited $400 per month into an investment which grew at 10% per year. 

One group was given calculators to work out an answer, the other group was given no aid and asked for a best guess.

The results? Both groups grossly underestimated the final value of the portfolio, as they failed to take compounding into account.

The average guess for the portfolio size after 40 years was $500,000. The correct figure is around $2.5m.

Little things mean a lot

Seeing the full benefit of compound returns is all about time and patience. That means that you don’t have to stash half your income away immediately. If you commit to putting aside as much as you can every month and making regular contributions, small amounts can soon add up.

Start thinking about your pension now

Thanks to the miracle of compound returns, the earlier you invest any amount of money the more it will be worth when you retire. Research group CLSA came to a dramatic conclusion about saving for retirement.

They found that if you contribute to a pension from the age of 21 to 30, your pension pot will be worth more than if you put aside the same amount each month from the age of 30 to 70. This assumes that you stop contributing at 30 but the fund continues to provide returns at the same rate.

Sources

1. Compounding: 8th wonder of the world, FT Adviser – 1 February 2017
2. Misunderstanding Savings Growth: Implications for Retirement Savings Behavior – March 2011

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 and forecasts are not reliable indicators of future performance. A pension may not be right for everyone and tax rules may change in the future. If you are unsure if a pension is right for you, please seek financial advice.