Important: This article is for general guidance purposes only and should not be considered investment advice. If you are unsure about the suitability of an investment, please seek out advice. When you invest, your capital is at risk.
Albert Einstein referred to compounding as the ‘eighth wonder of the world’ and Warren Buffett – one of the world’s most successful investors – is often quoted as having said, “My wealth has come from a combination of living in America, some lucky genes and compound interest.” But what exactly is compound interest and how can the rest of us benefit from it? Here, we explain all.
What is compounding?
In its simplest terms, compound interest is when the returns – or other income like dividends – on a savings or investment product is reinvested to earn you more interest, thus accelerating the growth of your wealth. Its power is subtle at first but can build up over time to have a fantastic effect.
Let’s say that you invest £1,000 and it earns 5% interest annually. After the first year, you would have £1,050 thanks to that interest. But, by the second year, you would have £1,102.50 because the next interest payment is working off a larger sum – and so on and so on.
Because your interest payment is working off a greater starting amount each year, the total gets incrementally larger faster. And that’s thanks to compounding.
What’s a dividend?
A dividend is a share of a company's profits that is distributed to shareholders. Depending on the investments that you choose, you may get regular dividends that are either paid out to you as cash or automatically reinvested.
Whether you choose to get your dividends paid to you monthly or yearly can have an interesting impact on your compounding strategy as we’ll see below.
Because your interest payment is working off a larger sum each year, the total amount gets incrementally larger faster
Monthly vs. yearly dividend reinvestment
Here, we’ll take an example of a dividend stock that returns 4% a year, where dividends are reinvested. In both cases, we’ll start with £1,000 investment. However, in one example, the dividend is paid once per year and in the other it’s paid monthly – 1% every three months.
Compound interest of an annual dividend stock
If there’s no compounding and an annual payout, you’d make £40 a year and have £1,800 after 20 years.
However, thanks to the power of compound interest, in this example you’d have a much more healthy £2,191.12 after 20 years, which doesn’t sound too shabby at all.
Now let’s look at the compound return for a £1,000 investment in a 4% dividend stock that pays out quarterly (1% per quarter).
Compound interest of a quarterly dividend stock
As you can see, the quarterly option provides more payments, which in turn provides more interest.
When should I begin compounding?
Whatever route you take, compounding is more effective over long periods, which is why most financial advisors recommend that people start investing and saving as young as possible – even if you’re not investing a lot.
Whatever route you take, compounding is more effective over long periods
If you start investing as a 20-year-old and compound your money until you’re 65, this is what you’d gain, according to calculations from Get Smarter About Money. The calculations assume you earn 6% a year and contribute £500 a month over that time. Interest is compounded yearly.
AMOUNT AT END OF YEAR WITH MONTHLY CONTRIBUTIONS
Compare this to an example where someone starts investing at 40 and contributes £1,000 a month. They make 6% a year – and this continues for 25 years, until they’re 65.
AMOUNT AT END OF YEAR WITH MONTHLY CONTRIBUTIONS
Of course, it’s never too late to start, but if you’re contributing more when you’re starting later, you end up with less because compounding doesn’t have as much time to work.
In this example, if you started earlier and contributed £75,000 less, you’d end up with a nest egg nearly double the size.
What types of investments typically compound well?
Stock market index exchange-traded funds (ETFs). ETFs are a collection of hundreds or thousands of stocks or bonds in a single fund that trades on major stock exchanges.
Individual stocks. You pick the companies you want to invest in and hold the stock. Companies can also embrace compounding by reinvesting their profits to make more profits. This hopefully has a similar effect on their share prices.
Dividend stocks. This is where you invest in a company that pays out dividends – either monthly, quarterly, biannually or sometimes yearly. These funds can be reinvested in the same stock or another stock to compound returns. Those reinvested funds will also make dividends/returns going forward.
Bonds. Also known as fixed-income or fixed-interest investing, bonds are loans made to a government or company and paid back with interest. These are a compounding investment, paying out interest at regular intervals. This can be reinvested in other bonds or stocks, compounding returns.
Accumulating ETFs. These stock or bonds ETFs don’t distribute any funds that are received from interest paid by bonds or dividend stocks. Instead, they automatically reinvest those funds. This differs from a distributing fund that pays these out.
What about savings accounts?
Wondering whether savings accounts are the way to go? Typically, savings accounts pay a less than 1% annual interest rate, according to consumer financial services company Bankrate.
For comparison’s sake, since the Great Depression the stock market has averaged roughly 8% to 10% returns annually. Long-term US government bonds have averaged more than 5% in annual returns, according to figures from Morningstar Direct.
CONTRIBUTED £500 PER MONTH
SAVING ACCOUNT AT 1%
BOND AT 5%
STOCK INDEX FUND AT 8%
Even over a few years, there’s a significant difference between a savings account and the average stock index fund or bond return.
That said, there’s little risk of loss in a savings account, while stock and bonds could easily lose money in some years. As a result, if you’re averse to risks, you might be better off just saving.
Even over a few years, there’s a significant difference between a savings account and the average stock index fund or bond return
How to make compound interest work for you
As you can see, you don’t need to be Albert Einstein (or Warren Buffett) to get on board with the principles of compounding.
The key thing to takeaway is that the longer you compound your interest, the larger the size of the prize. And the more frequently an account compounds interest, the more you’ll earn.
Capital at risk.