The Power of Compounding
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Some people online quote Albert Einstein saying "Compound interest is the eighth wonder of the world. He who understands it, earns it... he who doesn't... pays it." Whilst it can never be proven whether he actually said this or not, I do believe that compounding is an extremely powerful force and one that you need to make work for you.
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What is compounding?
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From a financial perspective it is the process in which an asset's earnings, from either capital gains or interest, are reinvested to generate additional earnings over time.
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The power of compounding is dependant on two factors:
- Annual Return
- Time Period
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The earlier you start investing, the more time compounding has to work its magic.
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If you invested £1,000 (principal) for 10 years, with a 10% return each year, you would have £2,594 in total at the end. Your money would have more than doubled despite not even topping up your initial investment.
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£1,000 Invested for 10 Years with a 10% Annual Return
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The reason for this is that the return you obtain each year increases because your starting balance at the beginning of each year rises with the return from the previous year added on. This is why in the 10th year the return is £236, whereas in the first year it is only £100.
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The best way to think of compounding is to imagine a snowball rolling down a hill. As the snowball rolls down it is able to pick up more snow and become bigger, which leads it to having an even bigger surface area, which allows it to pick up even more snow! Eventually the original snowball will become unrecognisable as it transforms into a giant boulder.
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The graph below shows £1,000 invested for 40 years with a 10% return. At the end of the 40 years, you would end up with £45,259. This is an exponential increase, which highlights how the time horizon for which you leave an investment to grow has a massive impact.
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£1,000 Invested for 40 Years with a 10% Annual Return
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It is worth noting that compounding can work for and against you. This is because whilst your investments can grow exponentially, so can debt. This is why it is so important to pay off all your debts as soon as you can (especially high interest debt) to ensure that it doesn't have the ability to spiral out of control.
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"Good and evil both increase at compound interest. That is why the little decisions you and I make every day are of such infinite importance." - C.S. Lewis
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