Magic of Compounding: Grow Your Savings

In Lost Savings Habit we discussed the prospect of younger generations ditching savings as a result of record low interest rates. According to a recent survey, a quarter of UK households would have to rely on loans or ask family and friends for help when faced with an unexpected bill. Young people may not receive adequate education about one of the most important factors they are going to have to deal with during their lives: money. 

If savers earn such minimal returns on their money in a savings account, it is worth asking what other options are there for investing? One route is taking advantage of the power (and magic) of compounding.

“Compounding is the process where the value of an investment increases because the earnings on an investment, both capital gains and interest, earn interest as time passes. This exponential growth occurs because the total growth of an investment along with its principal earn money in the next period.” – Investopedia

Lets consider an example of how powerful compounding can be over time. If you start with a $1,000 investment today and reinvest any income earned on the $1,000 over the next 5, 10, 20, 30 and 40 years, how much could you end up with?

Return 5 Years 10 Years 20 Years 30 Years 40 Years
4% $1,217 $1,480 $2,191 $3,243 $4,801
6% $1,338 $1,791 $3,207 $5,743 $10,286
8% $1,469 $2,159 $4,661 $10,063 $21,725
10% $1,611 $2,594 $6,727 $17,449 $45,259
12% $1,762 $3,106 $9,646 $29,960 $93,051

As the table above suggests, $1,000 invested at a compounded annual rate of 12% starting at the age of 25 would yield nearly $93,051 by the age of 65 (current age of retirement in the U.K.). This is an astounding return on investment in comparison with other current investment schemes. After all Albert Einstein thought that compound interest was “the greatest mathematical discovery of all time”. At a compounded 4% rate of return, it would take your $1,000 dollars just under 20 years to double your money. At 8%, it would take under 10 years.

“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it. Compound interest is the most powerful force in the universe.” – Albert Einstein

Einstein also highlighted the fact that compound interest is a double-edged sword. This is due to the fact that inflation, the erosion of purchasing power, also compounds over time. For example, a rate of inflation of 2% would take 36 years to cut your money in half in terms of what it affords. Excessive inflation has the potential to culminate in severe economic and political risks, as is currently the case in Venezuela (check out our article on that topic here). For a list of inflation rates around the world click here.

So what can we do to take advantage of compounding and minimise the impact inflation has on our savings? There is no single answer however one option is to consider what is called an Exchange-Traded Fund (ETF). In layman’s terms, an ETF simply ‘tracks’ a specific asset or group of assets.

For example, if you wanted to invest in Gold, you could purchase the GLD ETF. Or if you wanted to track the largest 500 companies in the U.S., you could purchase the SPY ETF. Significantly, the SPY ETF (like many stock-related ETFs) pays a quarterly dividend, currently yielding 2% a rate far higher than any savings account. This means if you continuously reinvest this dividend payment every quarter, you can take advantage of the power of compounding.

ETF’s are an incredibly powerful and low cost way of investing your money in the stock market (or indeed any asset class). Vanguard, for example, offers a wide range with some of the lowest fees in the industry. It is possible to invest in an Emerging Markets ETF as well as country specific ETFs (such as China or Japan). Click here to see some of the most popular ETFs available.

It is clear that taking advantage of compounding can be an incredibly powerful way to build up your wealth long term. ETFs are one such option of achieving this. Starting with a small lump sum and adding to your investment every month or two could be one way to build up your wealth. However, like all investments, there are risks associated to ETFs that investors should independently research, including market volatility.