In this week’s post, I’m going to give you the cold, hard truth about the compounding effect.
You’ve probably heard the term used online by self-proclaimed investing gurus. But what are they babbling on about? What does compounding mean? How does it really work?
But, more importantly, is it truly important, and if so, how can we use it to make the most amount of money?
Let’s dive right in.
What Is The Compounding Effect?
Simply put, “compounding” is the act of a repeated event, making something better or worse. Let’s say you’re already having a bad day, and something else goes wrong; it’s “compounding” your bad day into a terrible day.
Ever heard the phrase “adding insult to injury.”? Well, this is kind of how compounding works. Each ‘new’ thing is added on top of everything that came before it.
When it comes to money, compounding refers to money growing “on top” of itself. Bank interest is a great example of this. The interest you earn is paid on top of any money in the account, including any interest already paid previously. In other words, the interest earns interest.
It may not sound like a big deal right now, but bear with me. We’ll go through a few examples that will really blow you away.
Compounding is more powerful than you think.
As Benjamin Franklin said:
“Money makes money. And the money that money makes, makes money.”
Some Surprising Facts About Compounding
The key to maximising the compounding effect, is time. The more time something has to grow, the more unbelievable the results.
Here’s a simple example.
Let’s assume you have a penny. Just £0.01. This penny doubles every day for just 30 days.
- On day 10, you now have £5.12. Nothing to scream about, right?
- On day 20, you’ll actually have a surprising £5,242 and some change. Things just got interesting, didn’t they?
- On day 30, you’d be a multimillionaire, with a whopping £5,368,709 in the bank!
Okay, this example isn’t particularly realistic. So let’s do something more real.
Let’s say you take up a new hobby. You get just 1% better at that hobby per day, for one year. Sounds pretty doable, no? That’s because it absolutely is.
Believe it or not, you’ll be around 37 TIMES better at that hobby. That’s pretty wild! Here’s a quick graph to illustrate the compounding effect in this situation.
As you can see from this graph, you don’t see much progress in those first few weeks. After a demoralising TEN weeks, you’d only be twice as good as you were at the start. But this doubles again for each 10 weeks you progress.
At week 30, you’d have improved eightfold. By week 40, you’d be sixteen times better, and so on.
Why Does This Matter When Investing?
The above examples are not one-off situations. The compounding effect is relevant to so many areas of life. From education, to building habits, improving (or damaging) your health, to investing and building wealth.
In essence, the longer you keep at something, the more your efforts can compound.
It’s so easy to give up after a few weeks of creating a new habit, or beginning to save money. We haven’t seen meaningful results, so why bother?
But the truth is, if you don’t give up and persevere, more often than not, you’ll go from seeing little improvement, to exponential growth.
The compounding effect is especially important to consider when it comes to money; specifically, investing. Investing works in a similar way to earning interest on your money. The returns you earn compound over time; the longer you allow companies to grow, the higher the value of those companies – and thus your shares – can grow.
While the stock market can be volatile in the near term, investing in a diversified way (such as index funds/ETFs) has, historically, allowed people to build incredible long-term wealth.
In fact, the S&P500, which includes roughly the largest 500 companies in the US, has increased in value by an average of 10.75% per year. We’ll see what that looks like below.
But before you get excited and decide to invest as soon as possible, read our post on the eight things you must do before investing.
Investing Example 1
Okay. You now know how important the compounding effect is. You know that the key ingredient is time.
So let’s crunch some numbers with a real-world investing example.
Let’s assume you were given a lump sum £10,000 today, via inheritance. You invest all of the money into an index fund yielding 7% per year (of course, not guaranteed). You don’t intend to touch it for 45 years.
You completely forget about this £10,000, and don’t add a single penny to the pot.
Here’s what you have after 45 years…
In this particular case, your £10,000 investment would have grown to £210,024 in 45 years; a huge result! This is without even contributing more money, which of course most of us would want to do.
However, it’s unlikely you have £10,000 lying around to invest in one big sum tomorrow. So, what does this graph look like in an even more realistic scenario?
Investing Example 2
In this example, we’re going to keep the same assumption of a 7% yearly return.
But instead of investing in a lump sum, we’re going to assume you invest just £100 per month, every month, for 45 years.
In total, at the end of year 45, you’ll have personally contributed £54,100. Not bad, but that’s hardly a number to be excited about when you want to retire, right?
But, let’s take a look at how much your money would grow over that period.
At the end of year 45, you’d have a whopping £356,000. That’s more like it!
The best bit? You can double this simply by doubling your contributions. By increasing the monthly amount to £200 per month, your total contribution rises to £108,200.00, while your investment could become an incredible £712,001 after that same 45 years.
It’s worth noting that we’re using a modest 7% return per year in these examples. If you contributed just £100 per month for 45 years as above, but were able to mimic the past 50 years of investing returns, i.e., your investment grew by an average of 10.75% per year… You’d have a mind-blowing £1,157,303. You’d become a millionaire.
Want to play around with some numbers yourself? Here’s a FREE compound interest calculator.
Conclusion
Did the graphs in this post look similar? Did you notice a trend?
You’re absolutely correct; the compounding effect is universal. While the steepness of the curve may change from situation to situation, these graphs all show the same thing. In essence, time is the most important factor.
So, it’s safe to say that the compounding effect is powerful. So powerful, in fact, that it somewhat defies our instincts and feels unrealistic, despite the numbers being completely sound. We’re short-term creatures by nature; wired to focus on getting our next meal, or chasing that next thrill/experience.
But with some discipline, a reasonably small monthly commitment (and a whole lot of time), the compounding effect can provide a very comfortable retirement.
But as I said above, time is the secret ingredient. Which means the later you begin to invest, the more your monthly contribution needs to be.
Start today!
