InvestmentsFeb 1 2017

Compounding: 8th wonder of the world

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Compounding: 8th wonder of the world

The traditional system of buying rounds is one of my favourite things about British pub culture, and it is a practice that I have noticed is more prevalent here than in the US. It is nice to not have to go to the bar for each and every drink, and makes it logistically easier with minimal transactions.

This is rarely at the front of my mind in an actual pub, I promise, but as a market strategist, I can’t help but point out that there is a distinct economic advantage to buying a round at exactly the right time. Not too early, if the group might dwindle after a few; but more often than not, the group gets bigger and bigger. And before you know it, your colleague’s brother’s mate from university appears and you are fighting a 20-minute battle to reach the bar to get the whole pub their libations before last orders.

Investing is just the same: there is an economically advantageous time to start, and, mathematically speaking, that point is as early as possible.

Putting in small sums earlier in an investor’s time horizon can drastically affect their savings for retirement. The power of compounding is the third concept of our six-part Investing Principles series.

Compound interest has been called the eighth wonder of the world. Admittedly, not as architecturally stunning as the Great Pyramid of Giza or the Hanging Gardens of Babylon, but the power of compounding is so great that even missing out on a few years of saving and growth can make an enormous difference to your eventual returns.

In this week’s chart, we take an example of two individuals: one who starts saving and investing at age 25, and another who starts 10 years later. Each invests £5,000 per year in an investment that grows at 5 per cent a year. That annual growth rate could be higher if a more aggressive portfolio is used, or lower if the investor’s profile is more conservative, but we will use 5 per cent in this example. Starting at 25 years of age, putting £5,000 in each year, and growing the pot by 5 per cent each year leaves the first investor £639,199 at age 65. The second investor starts 10 years later, at age 35, and would have only £353,803, even though overall they would only have invested an extra £50,000. 

Then there’s an added layer of compounding that is also worth mentioning to clients. If an investor does not need the income, re-investing dividends can make even better use of the magic of compounding.

The difference between reinvesting – and not reinvesting – the income from your investments over the long term can be enormous. In fact, a one-off £5,000 investment in the FTSE All Share in 1986 would have grown to £28,357 at the end of 2016 - a robust return that most would be happy with. An investor who re-invested all dividends over the time period would now have £88,396 – more than three times the first (non-reinvesting) investor.

These are elementary concepts for most involved in the financial world, but for clients who may need some convincing to start early or may be hesitant to reinvest dividends, these two examples could be persuasive. Your money might not last as long as the pyramids. But you should have a better chance of being able to buy your grandchildren – and great-grandchildren – a pint.

Nandini Ramakrishnan is a global market strategist of JP Morgan Asset Management