What is compound interest and how does it work in real life?

We look at compound interest, one of the most important concepts for beginner investors to grasp.

Most of us will have some understanding of simple interest - ultimately the cost of borrowing money or the reward for saving it. But compound interest, also known as compounding, is one of the most important concepts for investors to grasp. It’s the gradual but powerful effect of getting returns on your money and returns on your returns.

Simple and compound interest are very different and shouldn’t be confused. Compound interest magnifies your gains over time in a snowball effect and it’s what makes time the most powerful ally an investor has.

Compound interest in real life

Imagine two people each invest £1,000 and get a return of 5% a year. This is just by way of an illustration; you are unlikely to get a uniform 5% in income and/or capital gain, but it keeps things simple.

The first person takes the 5% they made out each year and spends it, leaving just the £1,000 invested, the other keeps everything invested – their original money and all their gains. The table below shows what happens to their overall returns over time

Compound interest over time

In the early years, there was not much difference in how much the investors made. Yet over longer periods the power of compounding kicks in and the gains become larger and larger the longer the money is left alone.

Wondering how to work out compound interest? Simply use the below formula to calculate your projected returns:

FV = PV × (1+r)n

where FV = Future Value

PV = Present Value

r = annual interest rate

n = number of periods

Compounding in action - chart

This so-called ‘miracle of compounding’ is just straightforward maths but its remarkable effect reputedly led Albert Einstein to refer to it as the ‘eighth wonder of the world’. Here’s how the growth in returns looks on a chart:

Compounding is also responsible for the success of many businesses that invest for growth, as well as the large sums accumulated by famous investors such as Warren Buffett.

Buffett figured out the power of compounding at an early age when he bought a pinball machine and cut a deal with a local barber to install it in his shop. It was an instant hit, but rather than resting on his laurels he used his share of the money people spent on the first machine to buy another. He was then earning twice as much money and was able to buy a third and a fourth machine even quicker. Soon enough he had dozens of pinball machines in barbers’ shops all over town.

You don’t need a business mind or a smart strategy to benefit from compounding though. Investors harnessing returns in the form of capital gains and dividends benefit too. The essential ingredients are time and patience.

Three ways you can benefit from compound interest

1. Start early. The longer period you invest the more powerful compounding becomes. Take two investors, both investing for retirement in 40 years' time. One starts investing £100 per month right away, the other does nothing for 20 years, but then invests £300 per month. The investments are chosen both grow by 5% per year after charges. At retirement, the first investor will have spent £48,000 on their monthly contributions and the second investor £72,000. Yet despite having spent much less, the first investor's retirement pot would be worth £152,252 compared to the second investor's £123,310.
2. Don’t take too little risk. The greater the return, the greater the effect. Earning next to nothing on interest cash in the bank isn’t going to make compounding work for you to a significant degree.
3. Avoid taking excessive risk and sustaining large losses. Making a profit consistently is easier said than done, but a really big loss can be hard, if not impossible, to recover from. This is why taking a sensible amount of risk through a diversified approach is so important. That won’t mean losses are eliminated but it should limit the downside and allow a ‘slow and steady approach to keep working given enough time.

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