It’s possible for ordinary investors to turn a £10,000 lump sum into as much as £150,000. The only catch is that it may take a little patience.
Investors have a higher power on their side, known as compound interest. Physics genius Albert Einstein once dubbed compounding the “eighth wonder of the world,” and for good reason.
Its ability to grow wealth exponentially over time is nothing short of miraculous. Yet a new survey by Hargreaves Lansdown shows almost three quarters of us underestimate its power.
Joseph Hill, senior investment analyst at Hargreaves Lansdown, said millions fall behind in their retirement plans as a result. “Compound interest has something in common with other wonders of the world. To most people it’s mysterious and beyond comprehension.”
It’s worth taking a little time to understand how this little wonder works. Compound interest can transform relatively small sums into something sizeable. There’s a catch though. It needs time.
Compound interest is the process where the interest you earn on your initial investment also earns interest. Which earns interest too.
This creates a snowball effect, where your money grows at an accelerating rate over the years. Or decades, if you start early enough.
Time is the operative word here. The longer your money remains invested, the greater the compounding effect.
This is a particularly important lesson for younger savers. Many delay investing in their 20s because they have other priorities. Paradoxically that’s the best time to start.
The first £1 you invest is the most valuable of all, because it has longest to grow.
Say someone invests a £10,000 lump sum at 35 and it grows at an average compound rate of 5% a year, after charges.
By age 65, some 30 years later, it will be worth £43,219. It would have grown more than fourfold, which is pretty impressive.
However, if they’d invested the same sum 10 years earlier, at age 25, they’d have £70,399. Their investment term is just 25% longer, but their money is worth a staggering 62% more. All due to compounding.
Higher rates of return amplify the compound effect. So let’s say the same person invested £10,000 in shares at age 25, and generated an average return of 7% a year rather than 5%.
That’s roughly in line with the long-term total return on the FTSE 100.
After 40 years, they’d have £149,744. That’s almost than double the £70,399 total, yet the annual percentage growth was just 2% more.
Stocks and shares are more volatile in the shorter term, but over longer periods are far better at building wealth.
The average pension saver hopes to retire on an annual income of £48,868, according to new research from Royal London. This includes the full state pension which is currently £11,542.
To generate that in today’s terms, someone retiring at 67 would need a pension pot of around £696,000, with state pension on top.
That’s a daunting sum and inevitably, most will fall short. That’s despite the success of the auto-enrolment workplace pension scheme.
Royal London’s pension and tax expert Clare Moffat said auto-enrolment is terrific but isn’t enough on its own.
She said a 22-year-old worker who contributed 8% of their £24,000 starting salary into a pension under auto-enrolment rules would have £468,000 by 67, assuming compound growth of 5% a year after fees.
That would give them annual income of £36,600, some £12,200 below that £48,868 target. They’d need to invest more to plug the shortfall.
This shortfall highlights a critical issue: while compound interest can significantly grow our wealth, it cannot compensate for insufficient contributions.
Even miracles require a little human intervention. And the earlier the better
