The Curious Case of Compounding in Investing

Compounding is the 8th wonder of the world

There is a debate about who originally said: “Compounding is the 8th wonder of the world”. In an interview, famous investor Monish Pabrai mentioned that Einstein had been the first to say it, while in a blog post, the Data Driven Investor website noted that it has never been proven that Einstein ever talked about compounding.

Anyway, no matter who first said it, compounding is the real deal, not just in investing but in almost every aspect of our lives. Over the weekend, I was bored, so I decided to look at the compounding calculation and found some fascinating numbers that I couldn’t help sharing on the blog.

What fascinated me?

I used the Compound Interest Calculator to determine how much someone can save at any point in their life by saving a tiny amount every month.

For this calculation, the following numbers were constant.

  • Initial balance: £100
  • Interest rate: 6%
  • Compound interval: Yearly

Let’s begin!

In our first calculation, let’s assume that the person puts £100 aside every month for 60 years. After 60 years of saving and compounding, he will have £660,646 in his bank. For many of us, keeping £100 per month is easy. However, if you want to save for 60 years, you might need to depend on your pocket money or lawn-mowing income during your early days of saving. I have to admit that that isn’t easy, but not impossible these days.

Imagine that the person learned about compounding late and saved for 50 years. The calculation says he will have to save £184 per month to reach £660,533.

Wow, just for ten years, the monthly payment rose by 84%!

This increase in monthly payment blew my mind. So I kept reducing the duration by ten years and determined the monthly payment required for each period.

Initial InvestmentInterest RateDuration (Years)Monthly DepositFinal Balance
£1006%60£100£660,646
£1006%50£184£660,533
£1006%40£346£661,271
£1006%30£678£661,480
£1006%20£1,455£660,260
£1006%10£4,070£661,632

That is just mindboggling, right?

So, if you are super late to the game and only save for ten years, you will need to put aside more than £4,000 every month. I don’t know how many of us can do that after living in an expensive city and enjoying a normal lifestyle!

This means you might not be able to reach savings of £660K if you save for only ten years, ever!

Compounding in a real-life scenario

Let’s say you became a parent to a beautiful boy or girl, and you decided to save £100 per month for your child. By the time they reach university age (at the age of 18), your child will have more than £38K, which they can use to pay the tuition fees.

If they don’t use the money for their education, by the time they get married (at the age of 30, say), they will have £98K to spend on a lavish wedding!

So, you can see that a tiny amount of £100 can change our lives tremendously!

How to compound your money easily (warning: not guaranteed)

Before reading the next chapter, I warn you that I am not a financial advisor and know your personal situation. Also, past performance can’t guarantee a future return. Any figure and investment I mention are for education purposes only.

Firstly, you need a tax-exempt investment account as you will be investing your money for a long time, and the amount will grow bigger, so you want to avoid paying any tax.

A Junior ISA account will be the best option if you invest in your child’s future. A child under 18 years and living in the UK is eligible for a Junior ISA account. Currently, you can save up to £9,000 per year for each child. Visit the Government’s Junior ISA guidance and support section for further details.

If you are saving for yourself or any other adult, you should use an ISA account. Currently, you can save up to £20,000 each year tax-free.

Secondly, you need an average of 6% interest rate every year. No bank or financial institute can give you that high a return in the UK, so forget about a Cash ISA!

With a Stocks & Shares ISA, minimal effort makes this return possible.

Since its inception in 1926, the S&P 500 index has produced an average return (adjusted for inflation and including dividends) of 9.17% approximately(source).

If the stock market (and the US economy) doesn’t suffer years of abnormality, an S&P 500 index fund would be the most hassle-free investment vehicle. The S&P 500 index has returned a higher rate than the interest rate we used in our calculation. However, we must remember that the fund’s return rate will be lower than the index average as the fund manager and the investment platform will charge fees for their services. However, in my opinion, it will be still higher than 6% 🙂

Here is a list of the S&P 500 index funds:

S&P 500 vs VUAG vs IGUS vs CSP1

You can see that all these funds have returned more or less 29%, in line with the index. They are different from each other, so please look at their Key Information Documents (KIDs).

Finally, patience is probably the most critical quality every investor needs. If you are thinking of investing, no matter your goal, don’t delay. Starting from today, no matter how much you can invest, start investing. Once you start investing, please have patience; let it grow slowly. Don’t try to overdo it for a faster return, and don’t forget your monthly instalments!

Conclusion

I was not taught financial education in school, college or university – this is probably one of the greatest regrets of my life. I studied Physics, Chemistry, Biology, Geography, Programming and Accounting (I left the course after one week). As nobody taught me how to invest wisely, or the significance of compounding, I started very late and began investing as much as possible.

Don’t be me, don’t wait.

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