If you tell me about compound interest, I will automatically think of the traumatic experience I had in college trying to calculate it with pen and paper. Nevertheless, even I appreciate its unofficial title of “eighth wonder of the world” (in the words of Albert Einstein, it seems).
A quick reminder: compound interest occurs when small amounts of money turn into large amounts over time because the interest is reinvested.
Understanding the concept of it is quite easy; it is imperative to have a real idea of the financial impact this can have on your savings. In fact, the majority of people underestimate its power, which can lead to poor long-term financial decisions, such as a failure to save.
A survey by Orbis Investments earlier this year, for example, revealed how unintuitive the concept can be. In a hypothetical scenario, more than three-quarters underestimated the exact amount of compound interest a plan would earn. Less than 7% estimated within the correct range.
The question asked was: You invest £100 on behalf of a child in the stock market through a Junior ISA. Without a calculator, what is your best estimate of what the investment would be worth on the child’s 18th birthday if the stock market generated an average annual return of 8%?
The average estimate was £246. The correct amount was £400. I decided to revisit my trauma of calculating compound interest with a little more modern tools in order to visualize this impact.
Make money work again
Just like Orbit, we start with £100 in our imaginary investment portfolio, and we don’t add any further funding. After a year, this money would grow to £105 with an interest rate of 5% and to £120 with an interest rate of 20%. Fairly easy, and not much to write home about.
But as we saw with the junior ISA, the real power lies in long-term growth. If you’re as successful as Warren Buffett’s Berkshire Hathaway, which has grown 20% annualized for many years, you might consider turning £100 into £23,738 over 30 years. This, of course, is miles away from a 5% market cap over 30 years, which turns into £432 – but even that is a quadruple without ever touching the money or adding anything to it.
As you can see, if you want to accumulate wealth, starting early and focusing on getting the best return possible can make a significant difference.
So what if we want to add extra money to our investment portfolio? The table below shows how our savings would add up if we started with the same £100 but added an additional £100 at the end of each year.
The 5% 30-year return suddenly jumps from £432 to £7,076. And the 20% investment portfolio? From £23,738 to £141,926. That said, most of us will probably see mid-returns somewhere. And with inflation, that might be enough to keep money at the same value.
Identify quality stocks
When we last wrote about compound interest, my colleague Jocelyn Jovene made two important observations. Just being invested isn’t enough, as most of us have probably realized during this market downturn (dodgy bets on growth stocks? Yeah, me neither).
Getting into the most comfortable slice of the compound interest matrix requires careful study of key elements: the price you pay for the assets you invest in, their intrinsic qualities and their value. The same goes, of course, for funds, trusts and ETFs. Do you trust your fund manager to select these assets for you? What is their track record?
For example, if you want to invest your money in stocks, you will need to select high quality stocks that are currently trading at a cheap valuation. A high quality company will have a strong competitive position in its market, operate in a growing industry, generate a high return on capital, growing free cash flow, maintain a strong balance sheet and have capable management.
To Jovene’s second point, however: you can’t control the market. Likewise, you cannot control a company’s rating, which usually reflects the opinion of others about the company. But, if you are patient enough and know which assets you want to buy, you just have to be patient and wait for the market to give you the opportunity to buy something you like at a fair price.
But as Buffett says: time in market beats market timing, every time. Compound interest is proof of that.