Albert Einstein said, “Compound interest is the eighth wonder of the world. He who understands it, earns it… He who doesn’t… pays it.”
What is Compound Interest
Compound interest is interest calculated on the initial principle, which also includes all the accumulated interest from previous periods on a deposit or loan.
So if I deposit £100 with an annual interest rate of 2% after 1 year I will have £102. In the second year 2% interest will be calculated on £102 earning me £2.04 to give a total of £104.04. If over a 10 year period you were to deposit £100 at a 2% rate and leave it alone you will eventually earn £21.90 in interest for an overall return of 21.9%.
If you scale up the numbers you can quickly see how compounding interest can work heavily in your favour as an investor.
What about regular deposits?
The above worked example assumes that you have deposited £100 at a 2% interest rate (compounded annually) and then left it for 10 years. While good, it is hardly going to make you a lot of money. What if on top of the initial £100 deposit, you regularly deposit an additional £100 every month over the same 10 year period.
So in the first year you will have made total deposits of £1,200. At a 2% interest rate you would earn £12.96. The second year you will have made an additional £1,200 worth of deposits making the total principle deposits to be £2,400, plus the interest from the first year – £2,412.96. Therefore, you would earn £37.22 in interest in the second year.
After 10 years your total balance would be £13,281.58. Of that final figure £12,000 is your principle deposit and the remaining £1,281.58 is the interest earned over the 10 year period. Not bad!
Time is your best friend
Investing is a long term affair, it is not a way to get rich quickly. The earlier you start to invest and the longer you continue to contribute to your investments, over time you will build a large pot of money. Take Warren Buffett as an example, he bought his first stock at 11 years old, made his first million at the age of 30 and first billion at 56. In fact, 99% of his current wealth was made after the age of 50 all from long term investing.
That is my strategy, to think long term. If I make an investment, I not only intend to hold on to it for years, but continue adding to my investment. Over time it should grow to a point that I am happy with it. Anyone can do this and it does not take a lot of money to get started either. So the advice here is invest what you can, start early and see your money grow.
What if the stock market crashes?
Of cause over time the economy and markets will throw us curve balls, and it is important to know how to navigate them properly. Like with the current crash we have seen markets go down in the region of 30-40%. This can be very scary, but the worst thing you can do is sell. You will only have lost money if you sell, the market will always recover even if it takes a few years.
Between the years 2000 and 2019 the FTSE 100 posted an average total return of 6.47%. This includes crashes such as the dot com bubble and 2008. So had you invested £1,000 at the beginning of 2000, kept contributing £100 a month for 19 years you could have £47,255.85 now.
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None of the content in this article should be considered financial advice, I am not a financial advisor and you should always do your own research prior to investing. These are my opinions only.