DIY Investor Magazine
/
2015 Issue
38
….BUT NO CHICKS FOR FREE!
‘Compound interest is the eighth wonder of the world. He,
who understands it, earns it ... he who doesn’t ... pays it.’
Albert Einstein
How different could things have been if only we’d
known about the power of compound interest in our
callow youth?
If only we’d known then that the most important factor
in a successful investment strategy was its duration,
then we’d have done things differently wouldn’t we?;
one less Watney’s Party Seven and a few more entries
in that Building Society book.
Those new to DIY investing,
pondering the road toward their
financial objectives may call to
mind the punch line to a joke
that was definitely of its time
- ‘well Sir, I wouldn’t start from
here’.
And however tough we thought
we had it, spare a thought for
those recent graduates, trying
to make their way in the world
with the burden of student
debt, astronomically high accommodation costs and
constantly reminded that they will be facing abject
poverty when they retire unless they set aside the large
chunk of their salary that they could well do with to pay
their extortionate utility bills.
It’s tough, but whether you are planning for your own
financial future or looking to give a loved one a head
start, compound interest comes as close as is possible
to ‘money for nothing’ – and you can only start from
where you are.
HOW COMPOUND INTEREST WORKS
Compound interest is the multiplier effect of interest
being earned on interest, over time; the higher the
interest rate and the longer the period of saving or
investment the greater the end result.
For example a saver putting £100 into an account
paying 5% interest would have a balance of £105 at the
end of the year; 5% interest on £105 adds £5.25 in year
2 and so on:
Year
Principal
Interest @
5%
Total
1
£100
£5
£105
2
£105
£5.25 £110.25
3
£110.25
£5.51
£115.76
10
£155.13
£7.76 £162.89
If interest had been added only to the principal sum a
ten year investment at 5% would have yielded just £50
whereas compounding ‘miraculously’ yielded almost
£163.
OK, so that may not be a game changer, but what if you
add to that original savings pot by an additional £100
per year, and you build a portfolio of investments that
delivers 10% per annum in a tax efficient environment.
Then things look a little different:
Year
Principal
Additional
Investment
Interest
@ 10%
Total
1
£100
£100
£20 £220
2
£220
£100
£32
£352
3
£352
£100 £45.20 £497.20
10 £1629.54
£100 £147.29 £2012.29
By maintaining an additional investment of £100 per
annum, certainly things start to look a little more
interesting and as amounts increase and time horizons
are extended, compound interest can make a dramatic
difference to your financial outcomes.
Time is the key to generating such momentum – in the
above example £1,000 is invested in £100 tranches
over a ten year period; however, if this sum had been
invested in a lump sum at the outset, compound
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