What is Compounding
The compounding effect is found everywhere in life and is a vital concept for understanding how you can improve at anything including gaining wealth. In essence the compounding effect is the use of an improvement, gain, or new found value to create more success providing increased growth. In other words the gain on gain. This can also be visualised in another name it has been given – the snowball effect. Just imagine one rolling down a hill and you get the general idea.
By its nature compounding is a slow and steady approach. This can make it difficult to see the improvements from day to day. However, if you provide the consistency over a long enough time frame and the gap between where you are and where you started will be evident.
Compounding can be seen in many areas of life. Look at education for instance. In primary school you learn the basics of science, you then go into more depth at secondary, then A-level all the way past PhD. This process of learning is compounding in action as the base knowledge is expanded upon continually. The same can be seen in sport and fitness where the gains in strength, endurance, mobility or agility from one session, no matter how small, can be utilised in the next session to create more improvements. This concept of continuous growth brings us nicely to its use in finance.
Recommended Reading: Check out my early career retirement planning guide.
Compounding in Finance
In the financial space the compounding effect is commonly referred to as compound interest and is the backbone of investing and how all the famous investors have made their millions. Lets have a quick look at compound interest in action.
Currently in the UK the average instant access savings account is offering 2.73% interest per annum (August 2024). For simplicity sake lets use 2% as our figure as savings accounts have been a lot lower during this past decade. If we deposited £1000 and were able to lock into this rate for 35 years (the number of working years to receive full state pension), that £10000 would now be worth £20,125.80. If you were to do the maths you might have ended up with £17,000. For instance you found 2% of £10,000 (£20) multiplied it by 35 and added it back to £10,000 resulting in £17,000. In this scenario the compounding hasn’t taken place. This is known as simple interest. Instead you’d earn 2% on the interest you gained every year looking something like this, £10,000, £10,201.84, £10,407.76, £10,617.84 etc…
Now 2% isn’t a lot at all. In fact compare this to inflation and removing any account fees and you’re most likely losing money in terms of buying power but this will be discussed in detail in a future blog. When you apply this to investing is where compounding comes into its own.
Compounding in Investing
Lets look back to 1957 the S&P 500 was created. This investment fund holds the top 500 companies in the USA market and since its inception has produced an average of 6-7% annualised returns and these are inflation adjusted. Without inflation these gains are closer to 11-12%. Using 7% a £10,000 investment after 35 years would be worth £115,061.52. Using 11% and that turns to £461,760.50. This really demonstrates the power of compounding.
How everyone can utilise compounding
You may be thinking that’s great and all but I don’t have a spare £10,000 lying around. This doesn’t mean for own second you cannot utilise the compounding effect. if you read my prior post about investing you’ll know I don’t do too much lump sum investing as seen in the prior examples here. I instead choose to drip feed this in once a month on pay day. This method is also known as pound-cost averaging. If you invest into a pension you already do this probably without realising it. This strategy works wonders even for those starting small as demonstrated below.
The impact of saving monthly amounts over 35 years.
Monthly Deposits |
Total after 35 years @7% |
|---|---|
£25
|
£45,314.02
|
£50
|
£90,628.04
|
£75
|
£135,942.06
|
£100
|
£181,256.08
|
£200
|
£362, 512.15
|
If these figures don’t inspire you to get investing even at a small level I don’t know what will! The key thing is to be consistent and give it time to grow.
Recommended Reading: Learn how to create the perfect budget for you with Budgeting For Beginners.
Warnings
Obviously we can’t tell the future and using past history is not a sure way to estimate returns. The fact is this way has worked in the past for many people and if something like that were to happen over my lifetime then I wouldn’t want to miss out. In fact if there’s one thing I do know is people like to make more money and I don’t think that is going to change in my lifetime.
Another thing to be aware of is the volatility of the stock market. If we take VWRL an ETF tracking the global stock market, the average percentage gain over the past 5 years was 13.25%. The key word here being average. Look at the the table below and you’ll see the changes year on year are dramatic.
Percentage gain over the past 5 years between 01/09/2019 to 31/08/2024 for VWRL.
01/09/19 - 31/08/20 |
01/09/20 - 31/08/21 |
01/09/21 - 31/08/22 |
01/09/22 - 31/08/23 |
01/09/23 - 31/08/24 |
|---|---|---|---|---|
16.48%
|
28.45%
|
-15.67%
|
13.96%
|
23.25%
|
This goes back to what I was saying at the beginning on a micro scale it can be hard to see the improvement just imagine seeing your savings decrease by over 15%. But then you look at the macro scale and see over that 5 years you made a cumulative increase of over 66%! This shows how time in the market really does beat timing the market and the difficulty in getting short term gains.
Conclusion
Overall compounding is an effect that absolutely everyone can take advantage of financially. The key thing is finding an investment with a risk level your comfortable with and sticking at it long term to really get that snowball rolling. Happy compounding!
Disclaimer
All information is not financial advice and is purely meant for educational purposes only. Investing involves the risk of loss of capital as well as its gain. Any investments mentioned on this website are meant as examples not specific recommendations. Always do your own research and/or gain the help of a financial advisor.
