A wise man once reportedly said the following:
“Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”
Albert Einstein had a point, and it’s high time we explored it on this blog.
Compound interest is perhaps the most fundamental of all personal finance principles. For most everyday investors, it’s what underpins serious wealth accumulation. When we begin to understand that our gains feed our gains, we can transform the state of our finances.
That final point is worth repeating before we continue: our gains feed our gains. Let that sink in, because at its heart, this is what compound interest should be about.
Compound Interest: The Basics
Before we delve into some data, a quick recap.
Put simply, compound interest is the interest we receive (or pay) on our interest.
A Simple Example: Assume you invest £100 for 10 years and the investment returns (grows) at 10% per annum. In the absence of compounding, we might assume you’ll therefore return £100 (100 x 10% x 10 years). But this ignores the gains on our gains. Each year, our 10% growth applies on our new investment value. In other words, in Year 2, our return would be 10% of £110, in Year 3 10% of £121, and so on. Ultimately, our final balance would be £259 (a gain of £159). The effect of compounding interest therefore results in an additional £59.
Start Year Matters
You can quickly imagine the power of this effect over longer time horizons and with larger capital commitments, but let’s put this into perspective.
Introducing Jack, Jill and Jim.
Jack, Jill and Jim have the same birthday. When they turn 60, they plan to retire. Each of them invests £50,000 over 10 years into the stock market, returning 7% per year until they reach 60.
But there’s one important difference. Jack invests £5,000 per year from age 21 to 30, Jill from age 31 to 40, and Jim from age 41 to 50.
Now take a look at the graph below.
Just look at the difference that the additional investment time makes for Jack! Despite investing the same amounts (ignoring inflation), Jack winds up with almost double the final investment value of Jill and over £400,000 more than poor old Jim.
Simply holding his money in the market for longer yields a vastly superior financial outcome for Jack. But what does that mean for people like Jill and Jim? Are we doomed if we haven’t started investing at age 21?
Timing Matters (Sometimes)
The good news is that late starters aren’t doomed. Of course, the final value of our investments will also depend on how much we put in and where we put it. But our previous illustrative example also misses a fundamental point about personal finance: no investment in the stock market will return 7% every year. Returns simply don’t look like a straight line over time.
In reality, returns look less like this:
And more like this:
That last graph shows the annual growth of the S&P 500 from 1980 to 2019. As you can see, it’s been a bumpy ride. But if you stuck it out, you’d have got an average nominal return of 10.1% per year.
The salient message from this graph is that timing can matter. Imagine for a moment that Jack’s tenth year of investment fell on one of those troughs (those are mainly recessions). His entire investment value would be impacted by that year’s stock market movement. And then Jill would get the early benefit of the recovery as she begins to invest.
Let’s explore this idea by building on our example of Jack, Jill and Jim.
Imagine that they still invest £50,000 over 10 years at age 21, age 31 and age 41, respectively. But this time, let’s move their 60th birthday. Based on S&P 500 historical returns, what happens to their investment values as their start and ending years shift?
I modelled this scenario spanning 93 years and the below are the investment values of Jack, Jill and Jim when they reach their 60th birthday.
Long story short, having reviewed returns since 1927, there is just one 60th birthday year in which the same investment would produce a better final investment value for a later investor – and only just.
As you can see from the graph above, that year was 1967, and it’s a result of Jack’s tenth investment year being the worst S&P 500 year in recorded history (it dropped 38.6% in 1937 and it meant Jill just pipped Jack to the post on their 60th birthday).
In all other years, despite having invested the same amounts, Jack’s final investment value exceeded Jill’s and Jim’s. What’s more, the value of Jack’s investment grew considerably more as we shifted the timelines to more recent years.
Having said that, the peaks and troughs in this graph tell us that timing of entry and ending of regular contributions can matter hugely to the final values for all three investors.
The other important takeaway here is that the longer we are regularly investing into the market, the closer our returns will resemble long-term averages. In effect, investing regularly over a longer period (more than 10 years in this case) can go some way to smoothing out some of this volatility.
Other Stuff Matters
There are a few final points that our discussion of compound interest has missed so far.
#1: Asset Allocation: The above examples assume Jack, Jill and Jim stick all their money in US equities and put their feet up. In reality, strategies that diversify our asset class exposure and broaden our international exposure can reduce risk without necessarily compromising returns. In addition, an active strategy of shifting between asset classes (e.g. investing in precious metals during downturns) is risky but could also strengthen Jill’s position relative to Jack’s.
#2: Black Swan Events: Our gains feed our gains, but unpredictability means this is far from a straight line. Recessions happen, but so does the wholly unpredictable. Few considered a global pandemic a serious threat to the global economy before 2020. The point here is again timing and opportunity. Suppressed prices can penalise those in their final years of investment and reward those at the beginning. Our gains do not compound on our gains linearly.
#3: Inflation: The above examples consider our nominal returns and investment, and not the time value of money. In reality, our real investment reflects the purchasing power of our money. Jill and Jim therefore invest less than Jack in real terms, but that’s a story for another time.
#4: Away from the Upside: We have focused our attention exclusively on the glamorous side of compound interest: our gains feeding our gains for wealth creation. But we can equally invert the concept to wealth destruction: being charged compounding interest on our interest. The perils of expensive debt are a whole other discussion, but worth considering as we weigh up where to allocate our money to maximise our compound gains.
The Power of Compounding
As our global economy takes a new shape, led by digitalisation and a new age of fiscal and monetary policy, it is worth reminding ourselves of the importance of compound interest.
Make the right choices consistently, start the right habits and stick to them, show up with your money over the long run, and your gains could feed your gains like never before. Be prepared to stick it out and the power of compounding could transform your life.