If you ever wondered how Warren Buffett turned $105,000 into a $65+ billion fortune, the simple answer is... compound interest!
Compounding – as it’s also known – is an investor’s best friend, and the single biggest contributing factor to building wealth. It’s the snowball effect of earning interest not only on your original investment, but on your returns, be they in the form of interest, dividends or capital gains. Earning interest on interest may sound a bit paradoxical, but the collective effect is, your money grows faster and faster as the years pass by.
And the effects of compounding are even more pronounced when you invest via a tax-efficient wrapper, such as an investment ISA, which lets you keep even more of the interest you earn.
Compound interest is the eighth wonder of the world. He who understands it, earns it….. he who doesn’t ….pays it.
Should I start investing early?
Many young investors procrastinate over their investment plans without realising that each passing year is an opportunity to earn compound interest that they’ll never get back. The importance of starting investing as soon as you possibly can, far outweighs the significance of finding the ‘perfect’ investment. It’s a rule that applies to any savings goal - retirement, buying a home, or saving for some other purpose –the longer the time frame, the more powerful the effect of compounding on your overall return.
Suppose your ambition is to become a millionaire by the time you retire. Saving £300 per month in an ISA investment from age 22 and earning an average annual return of 7%, you will be a millionaire by your 66th birthday. Wait until 32 to start saving and you will have to put aside £650 per month to reach the same goal by 66.
So, the later you start, the more cash you will have to commit each month to achieve the same results - or, in other words, the earlier you start, the better. That’s the beauty of compounding.
The power of regular investing
A common dilemma investors face is market timing. Jumping in and out of markets on a regular basis not only requires constant monitoring of daily events, but also requires the skill to act on such events.
However, investing a set amount every month, sometimes referred to as ‘Pound Cost Averaging,’ helps to smooth out the ups and downs of the market by allowing you to buy more shares when prices are low, and fewer when they are high, ultimately boosting performance when markets recover and helping to better compound your investment returns over time.
By starting to invest as soon as you are able to, and by employing a disciplined investment approach of investing on a regular basis, you can benefit from the extraordinary power of compounding and reach your financial goals more quickly.
Please remember that the value of your investments can go down as well as up and you can get back less than invested.