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1st June 2014

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James Yardley, Research Analyst

As Albert Einstein once said, compound interest is the eighth wonder of the world. He who understands it, earns it.... he who doesn't pays it. I couldn't agree more and, in my opinion, it is possibly the most important concept people can learn about when it comes to their finances.

Compound interest, put simply, is 'interest on interest'. It assumes that any interest on an initial investment or debt is re-invested at the same interest rate in subsequent periods. Most readers are probably familiar with the concept, but in my experience few people recognise compound interest's true power. To demonstrate what I mean consider the following example.

An investor invests £1 a day for 70 years and achieves an annual rate of return of 7%. All income is reinvested and interest is compounded monthly. How much is the investor left with after 70 years? How much would you guess?

The answer is £685,245. The power of compound interest is considerable and it has many lessons to teach investors.

However, this example also warns how compound interest can work against you. It shows the danger of debt and how a situation can quickly spiral out of control. Let's consider a payday loan example with 5,853% annual interest, which is the rate attached to one of the most highly publicised deals.

Consider a £100 loan taken out today at a 5,853% interest rate compounded annually. The amount owed in just a year's time would be £5,953. If this loan went unpaid over two years the debt would grow to £354,382! Within four years the debt would be £1.25billion. Yes BILLION! Now, I'm not an expert on payday loans, so hopefully the debt would never be allowed to go unpaid for this long. But the shocking numbers do help illustrate the first lesson to be learnt from compound interest: pay off any debts before you consider investing.

The next lesson is that there is no amount too small to start investing. It’s also important to start investing early. The fact we invested for 70 years in the example above was crucial. Starting earlier gives you a huge advantage. No matter how little you have to invest, it is still worth doing. If we had wanted to make the same £685,245 in 50 years, under the same conditions, we would have had to invest more than £4 a day instead of just £1. It may seem like there is never a good time to invest but the earlier you start the better (subject to first paying off debts as covered above). Now investing £1 a day isn't really practical, particularly if you are charged for each transaction! But you can invest as little as £50 a month quite sensibly and cheaply.

Staying in it for the long haul

Our example demonstrates how crucial it is to stay fully invested and to keep re-investing any interest. Investors who pulled out of markets in 2008 when the global financial crisis began and didn't return have missed out on the huge rally we have had in the six years since. If you're investing for the long term it is important that you hold your nerve when the market is struggling and continue investing.

Income Producing Assets

Another important lesson we should take from compound interest is the value of assets, which generate an income, which can be re-invested. Warren Buffett guarantees that farmland will out return gold over a hundred year period. The reason being that farmland can produce crops which can be sold. The investor can then use the proceeds to buy more farmland and the original farmland will still be producing crops one hundred years later. Gold will sit there and you will have to pay someone to store it.

Rate of Return

The final lesson we can learn is that the rate of return you achieve is crucial. If we go back to our original example and replace the 7% return with 5%, the final sum falls to £232,724. Still not a bad sum considering the amount invested, but it does show how the level of interest rates or returns can make a huge difference. It is worth doing your research on the funds in which you wish to invest.

Conclusion

The lessons from compound interest are clear. Pay off your debts, start investing early with whatever you have, and stay in it for the long haul. It’s very hard to get rich quickly but it’s quite possible to get rich if you keep re-investing and you have time on your side.

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. James' views are his own and do not constitute financial advice.

Compound interest example calculations sourced from:

http://www.moneychimp.com/calculator/compound_interest_calculator.htm