You Don’t Need to be Einstein to Understand Compound returns
Smart chap, that Albert Einstein. He understood things most of us couldn’t possibly hope to wrap our minds around.
E=mc2? You can read that “energy equals mass times the speed of light squared” over and over and all you’ll get is a headache.
Or you could read something else Einstein is claimed to have written, and instead of a headache, you’ll get an idea of just how powerful the right financial decisions can be.
“Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.”
It’s better to earn than to pay. So, let’s help you understand.
Understanding Compound Interest (when you don’t have a Nobel Prize)
Imagine you have a bank account. Easy enough.
Now imagine that bank account earns a 4% interest rate. In this climate, that’s a little more difficult.
Put £100 into that bank account, and you’ll have £104 after a year.
After 2 years? £108.16. The interest on your interest has earned an extra 16p. Not a lot but bear with me.
Year 3 is £112.49. That’s an extra 49p on top of the 4% your £100 earns each year.
Fast forward to year 20, and you’ll have doubled your money.
Compound interest means you earn interest on your interest, and like a snowball rolling down a hill, picking up more snow as it goes, your investment will pick up more and more accumulated growth along the way.
No Nobel Prize needed to get your head around that.
But What About Real Assets?
If you’re investing in real assets, like shares, you earn compounded returns in a different way.
Not only do real assets produce income, the value of the capital can also rise over time, which helps to accelerate the compounding.
So, rising asset prices and rising income, which in turn buys more rising assets and rising income, means that snowball is now more akin to an avalanche
Let’s explore a scenario. We take our £100 from before, and invest in a fund whose share/unit price grows at 5% a year, and also pays a 4% annual dividend.
Instead of your money doubling in 19 years, it doubles in just 10.
By year 16, it will have tripled.
Now in real life, we know that investment funds and share prices don’t tend to rise in a straight steady line and dividend will fluctuate or even be suspended. But you get the gist – compounding within real assets can deliver bigger results than savings.
Knowledge is a Powerful Thing
It’s no good knowing that E=mc2, unless you’re an accomplished scientist like Albert Einstein. There’s nothing you can do with that knowledge. But now you know how powerful compounded growth can be, you can put it to use in four ways:
1. By not keeping too much cash. Savings interest (if you can find it anywhere) will compound, but not as quickly as real assets. Save the cash you need for emergencies, invest the rest, and let compounding do its thing.
2. By not being distracted by yesterday’s chip paper. Short-term market or geopolitical events might seem like a reason to run for the hills, but they pass. And selling up during a short-term blip is a shortcut to kissing your compounding goodbye.
3. By playing the long game. That snowball needs time to build up momentum. The longer compounding has to work, the bigger the avalanche it’ll build.
4. By keeping an eye on investment costs and tax. Cheap is by no means best but the more expensive a fund is and the more tax it pays, the less of your money gets to benefit from compounding. But, you can control these things to a large degree.
So sit back, relax, and let compounding do the work for you. We’ve seen first-hand how sensible investing combined with the magic of compounding has helped our clients achieve their financial goals.
Many of them even have enough to look after their families too. We call that effect the Investment Theory of Relativity (sorry).
Thanks for reading.
Please note that equity investments do not afford the same capital security as deposit accounts. The value of your investment (and any income from them) can go down as well as up and you may not get back the full amount you invested. Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.