The Power of Compounding Revealed

Analysis from Fidelity International reveals how compound interest could significantly enhance your returns.

Fidelity’s calculations look at the investment habits of two hypothetical investors to show how your returns can grow exponentially when exposed to the power of compounding – the repeated addition of interest to both your original savings as well and the interest already earned on that starting amount.

Our first investor, Investor A, invests £1,000 a year into the stock market from the age of 18 and keeps doing so for the next 20 years. By the time they reach 38, and based on an annual return of 5 per cent, their investment would be worth £34,719.

At this point, Investor A decides to stop making any further contributions. However, their investments continue to generate a 5% return each year. Due to the phenomenal power of compounding, over the next few years their savings starts to grow exponentially and begin to dwarf the original amount that was saved and by the time they reach 65, their investment has grown to £129,623.

Our second investor, Investor B, doesn’t start their investment journey until they are 38. Like Investor A, they invest a £1000 a year and achieve a 5% return per annum.

However, even with Investor B saving £1000 each year all the way up to the age of 65, thereby investing an extra £7,000, they are unable to catch up with Investor A’s portfolio.  At 65, Investor B’s portfolio is worth £57,403, less than half of investor A’s.

The stark difference in the value of the two portfolios is explained by time – the 20 years in which Investor A’s money was working and Investor B’s was not. Time is the key component of compounding and the sooner you are able to start investing, the more powerful it becomes.

The power of compounding:

Source: Fidelity International, September 2017

Tom Stevenson, investment director for Personal Investing at Fidelity International, comments:  “Compounding is an incredibly powerful force that can make an enormous difference to your savings and investments. It’s small wonder then that Albert Einstein called compounding the eighth wonder of the world.

“As our calculations show, the sooner you invest, the more time your money has to grow and the greater the impact of compounding will be. On the other hand, if you choose to put off saving into an ISA or pension by just a few years you could end up forever playing catch up. This can have a huge knock-on effect on your ability to reach your financial goals or have a comfortable retirement. With this is in mind, it’s sensible to start to save as soon as you can.”