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The Magic of Compound Interest

Starting with a little early on can lead to a larger savings pot than starting later with a lot, thanks to compounding interest

Holly Cook 14 February, 2011 | 12:02PM

Many people, particularly the younger echelons of society, put off saving in the belief that they cannot afford it. But starting early can have a significant impact on the size of your eventual savings pot. Compound interest, or the eighth wonder of the world, as it is sometimes referred to, is often explained with the following trick question: "Would you rather have £1,000 per day for 30 days or a penny that doubled in value every day for 30 days?" Those in the know would choose the doubling penny because, at the end of 30 days, they'd have accumulated about £5 million versus the £30,000 they'd have if they'd opted for £1,000 per day.

Compound interest is often called the eighth wonder of the world because it seems to possess magical powers like turning a penny into £5 million. The great thing about compound interest is that it applies to money and helps us to achieve our financial goals, whether they are to become a millionaire, to retire comfortably, or to be financially independent.

How Exactly Does it Work?
The principle is simple: A pound invested at a 10% annual return will be worth £1.10 in a year. Invest that £1.10 and get 10% again, and you'll end up with £1.21 two years from your original investment. The first year earned you only £0.10, but the second generated £0.11. This is compounding at its most basic level: gains begetting more gains. Increase the amounts and the time involved, and the benefits of compounding become much more pronounced.

So, having established the benefits of compound interest let’s see how it can help us in our everyday financial planning. All of us have financial goals set into the future that we aspire towards, be it simply repaying the mortgage for more financial freedom, saving enough to ensure a financially secure retirement, or taking the holiday of a lifetime.

Here’s the primary principle with all of the above: the earlier you start, the more likely you are to achieve your goal.

What will Your Investment Strategy Be?
Let's look at a simple example of two starry-eyed young men--let’s call them Del and Rodney--both of whom aspire to become millionaires. Sensible Rodney decides to save his pennies and, from age 24 to 30, manages to invest £2,000 per year in a portfolio recommended by his financial advisers, Trigger & Co. His investments grow each year by 12% net, and, although he stopped saving after he reached age 30, he left the money invested where it continued to earn 12% each year until he retired at age 65. Del, on the other hand, carried on spending all his money for another six years before he too started saving £2,000 per year at age 30, also earning 12% net per year through the good offices of Trigger & Co. However, Del was able to continue investing £2,000 per year until he retired at the same time as Rodney.

So, did either of them achieve their goal of making a million? In the end, both of them just about made it. The difference is that sensible Rodney, because he started early, had to invest only £12,000 (i.e., £2,000 for six years), while big-spender Del had to invest £72,000 (£2,000 for 36 years) or six times the amount that Rodney invested to get to the same point. Therefore, that six year delay effectively cost Del £60,000.

A Lesson Worth Learning--and Applying
The lesson is that investing sooner rather than later can be at least as important as the actual amount invested over a lifetime. Therefore, to truly benefit from the magic of compounding, it's important to start investing – or repaying debt because the same principle applies in reverse – at the earliest possible date. The idea, prevalent among many people planning for their retirement, that what they do in their 20s and 30s doesn’t matter, is a fallacy. Always remember, due to the effect of compound interest or compounded returns, gains beget gains, which beget even larger gains. This is the true magic of compound interest.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author Holly Cook

Holly Cook  is Managing Editor of Morningstar.co.uk