DIY Investor Toolkit: We reveal the one thing that investors of all persuasions should not underestimate.
Whether you prefer to invest in funds, shares or simply to passively “buy the market”, there is one thing that you should not underestimate: the power of compound interest, achieved through investing for the long term.
Albert Einstein allegedly described compounding as “the greatest force in the universe” and also apparently mused that “he who earns it, understands it; he who doesn’t, pays it”. While the debate will no doubt rumble on regarding the authenticity of the quotes, as far as investors are concerned, the power of compound interest is not up for debate and should not be ignored.
In a nutshell, compound interest refers to the way investment returns themselves generate gains. For instance, if you invest £1,000 into a fund returning 5% over one year, you’ll earn £50. Assuming that you don’t withdraw any money, the next year you’ll earn 5% on £1,050, which is £52.50. This doesn’t sound like much of an uplift, but as each year passes, the compounding effect multiplies.
The effect becomes even more powerful when mixing compounding and reinvestment of dividends. Indeed, over the long term, dividend growth is where the vast majority of the stock market’s returns come from. One of the key takeaways for beginner investors looking to improve their odds of stock market success, therefore, is to invest for the long term and reinvest both capital gains and income. Those who do will reap the rewards of compounding.
Another lesson is to invest as early as possible. Research from Orbis, the fund manager, hammers this point home. It looked at how a £100 investment returning 6.5% a year would fare over different time periods.
Orbis found that after 10 years compound growth on the £100 investment would produce a return of £81. This figure, though, would fall to £70 if the same investor started a year later and left it for nine years. Dan Brocklebank, UK director of Orbis Investments, says: “Every year of delay in investing lessens any potential growth considerably.”
He adds: “Many have heard about that quirk of maths called compounding or compound interest, but even those who understand it often don’t realise just how astounding its effect can be, leaving many long-term investors at risk of missing out on the chance to “grow their growth”.
“The good news is that you don’t necessarily need to know exactly how to calculate it to reap the benefits. Compounding means investors can get much more out of their portfolio than they initially put in, as long as they can resist cashing in any of those short-term returns.”