“Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.” - Albert Einstein
This post is taken from chapter two of Stop Saving Start Investing. All rights reserved.
I’m sure you know the story of the tortoise and the hare. The hare sprints ahead of the tortoise in the beginning, before taking a nap under a tree. The slow, plodding, risk managing tortoise eventually takes over the hare and wins the race. The tortoise is patient and knows that the race is long.
When it comes to investing it’s usually the tortoise who gets rich in the end. This is because investing is a long-term game, and ‘get rich quick investments’ based on hunches or ‘expert tips’ often end in disaster.
The tortoise beat the hare because he had the better long-term strategy. Think like the tortoise and you’ll go far with your investments!
The maths behind compounded investment returns
In this post, I’ll show you some examples of how earning compounded investment returns can make you very rich over time. Before that, I first need to explain the simple maths behind how compounding works.
Say you have a £1,000 investment that grows by 10% each year. During the first 5 years, your investment grows slowly, like this…
Notice that each year you make a little bit more ‘money return’ than the year before. This is because you earn a 10% investment return on a larger number each year.
This may not seem like much to start with, but look what happens 10 years later…
And another 10 years after that…
It’s clear from these numbers that the saying “it takes money to make money” holds true. This is down to basic maths. The same percentage of a larger number creates a bigger number. The same percentage of that bigger number then creates an even bigger number, and so on.
The below example shows what happens when you invest money each month over many years. The results may surprise you!
How time affects compounding
1. You invest £4,000 each year (just over £330 per month) into your investment portfolio.
2. You earn a 10% average return each year on your investments.
3. You do not withdraw any returns from your investment portfolio.
The table below shows how your money would grow each year...
In the first 5 years, your portfolio grows to £27,000. But in the last 5 years, it grows by nearly £300,000 (£724,000 - £433,000). This is despite the fact that in each 5-year period you would invest the same amount of money, £20,000, into your portfolio.
Let’s think about that for a second. In the first 5 years, you would make £7,000 (£27,000 - £20,000) in investment profit over what you invested in that time. Not too shabby.
In the last 5 years, you would still invest the same £20,000, but your total return would be 15 times that amount, or £300,000.
Over 30 years, you would invest a total of £120,000 of your own money. The other £604,000 (£724,000 - £120,000) would have effectively been created out of thin air.
So, in this example, after investing your money for 30 years you’d be about 7 times wealthier than you would if you kept that money in a savings account earning minimal interest.
The first law of compounding
The above example on proves the first law of compounding:
Your wealth grows faster with time if you earn a positive average return on your investments.
This is what the legendary investor Warren Buffet describes as "the snowball". As the snowball rolls down the hill it grows faster, picking up more snow with each successive roll.
How return affects compounding
The 10% average return assumption I used in the last example is just a number to show how compounding works. It may be that your goal is to average 5, 15, or even 20% return each year.
The table opposite shows how long it would take you to grow your portfolio to £500,000 using the same assumption that you invest £4,000 per year, but with different average returns on your investment:
Note: Averaging 20% return per year over long time frames is possible but requires you to master advanced trading and investing strategies.
The above example shows a clear pattern. As your percent return goes up, the time taken for you to become wealthy goes down. Or, put another way:
As your investment return increases, your wealth grows faster
The results from the above table should come as no surprise:
The more money you invest, the faster your wealth grows
You can massively grow your wealth over time through your investments, so long as you are willing to put in the effort to either:
If you would like to learn more about investing in funds, check out this book.