The Joy Of Compound Returns

Posted by John Adam on July 15

Saving and investing comes naturally to some and is a real struggle for others. But it’s probably fair to say that for most of us, setting money aside every month with a view to an abstract future is some sort of challenge. Life is expensive anyway and staying within budget usually means making choices. It’s human nature for it to be harder to take choices that sacrifice our shorter term satisfaction for a bigger picture that means holding off on gratification. Especially if that delay is one we won’t see the payday on for years or even decades. And that’s what investing usually means. Saying no to certain things today and tomorrow to be able to say yes to more later in life.

But the sooner anyone starts investing, the easier it is to hit long term targets. And not just for the blindingly obvious reason that the more months and years an investment target is divided by, the smaller the equally divided instalments that add up to that final target value become. It actually becomes a good deal easier than that.

The reason is the ‘compound’ returns that give your investment pot a very nice boost over the long term. Compound returns basically work in exactly the same was as interest on a credit card balance, loan or mortgage. Except that this time, it’s in your favour.

Compound returns, which are also sometimes referred to as compound interest, come from reinvesting any returns earned from an investment back into the same investment. It’s what most investors do until the moment they want to start taking an income or cash lump sum from their portfolio. And over many years, compound returns can grow the value of an investment portfolio by a lot more than most investors actually realise. Which is why, with more time, reaching investment targets becomes much easier than just dividing the final target over more instalments.

Let’s see how just how powerful compound returns are through a couple of concrete examples:

Investor A and Investor B have both started an investment portfolio by investing a £10,000 work bonus. The two have both invested their £10,000 in the same tracker index on the same day and plan to leave it there for 30 years.

At the end of each year, Investor A plans to withdraw any returns generated by the £10,000 investment and put them towards a holiday. Investor B plans to reinvest them back into the same index tracker fund. Investor B’s approach is to compound the returns.

In our theoretical example, the £10,000 investment earns an average annual return of 7%. That’s £700 a year which Investor A puts towards a nice trip somewhere or a total of £21,000 earned towards holidays over 30 years. By investing that £10,000 bonus, Investor A has received back more than double the original sum to spend on something enjoyable. And still has the original £10,000. Not bad.

But at the end of the 30 years, Investor B has earned not £21,000 from the original £10,000 but £76,123. That’s a lot more than triple what Investor A made and is because every year Investor B’s 7% is earned on the original £10,000 plus all the 7% additions to that total over the years.

Investors normally also keep on investing over the years. What happens if both Investor A and B compound their returns and invest another £10,000 every year but Investor A will retire in 15 years and Investor B in 30?

After 15 years, Investor A’s portfolio value reaches £278,880.54 with compound returns. After 30, Investor B’s reaches £1,020,730.41. The second 15 years doesn’t just double the £278,880.54 portfolio value reached over the first 15 years - it more than triples it. Because every year, new returns are made on a larger starting value.

Which is why it’s so useful to start setting money aside towards long term investing goals as early as possible. Compound returns mean another 5, 10 or 15 years investing makes a big difference – a far bigger difference than just the extra money invested over those years adds up to alone. And that difference means you can either invest less every month to reach the same final total. Or invest the same amount for a much larger final pot.

Either way, it just makes sense to take advantage of the great boost compounded returns add up to over the years by starting to invest as early as possible.

Written by John Adam

John has almost 10 years of experience as a writer and editor on consumer finance and investment topics. An entrepreneur, he has one successful exit behind him and currently writes and consults freelance while enthusiastically pursuing hobbies he's not very good at such as football, squash and raising a small child.

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