Compound interest

The Squeeze: compound interest – the eighth wonder of the world

Investor sentiment is falling every day in the face of war and inflation. Given this, it seems like the time has come to discuss the magic of “compound interest”. Albert Einstein (allegedly) described it as the “eighth wonder of the world”. And while it’s a simple concept, we need to remind ourselves from time to time of the power of exponential growth.

The provision of financial education is patchy in the UK, with only around a quarter of adults able to count functionally according to the charity National Numeracy. This may partly explain our low savings and investment rates – surely if more people understood the power of compound interest, they would put it into practice.

But the idea is simple to understand. Vanguard Senior Financial Planner Zoe Dagless uses a 6% annual return in a recent example of an article focused on young investors. Dagless said an investor who saves £262 each month from age 25 would have an investment pot of over £500,000 by the time they hit 65 (this does not take into account platform fees or reliefs potential additional taxes). The crux here is that around £375,000 of the final pot comes from capital growth – that’s the power of compounding.

And we can clearly see the benefits of starting to invest early. The same investor would need to save £514 a month from age 35 or more than £1,100 a month from age 45 if they wanted to reach the same final pot, Dagless said. It is essential that young investors understand this.

At least that’s the idea. But there are of course no guarantees to invest – Goldman Sachs warned last year of a “lost decade” for returns in traditionally weighted portfolios. With soaring inflation, rising interest rates and the reversal of globalization, the structural factors that have driven stock prices higher over the past decade are under threat. According to Vanguard, the FTSE All-World Index has posted an average annual return of 9.9% since 1993 – this is unlikely to happen again in the next few years.

History is not always guaranteed to repeat itself, but the precedent is clear. Christopher Rossbach, Chief Investment Officer of J. Stern & Co, pointed to the asset manager’s analysis which shows that “even if we face headwinds…even if we experience a few years of volatility in stock market performance…if our holding period is five years or more, so the chances of us not making a positive return are next to zero.” Keep investing for the long term and enjoy the magic of compound interest.

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