If you read money related articles at all then you may well have come across the concept of compounding.
Some even refer to it as the power of compounding, because it really is an incredibly powerful formula that can drive investment returns.
Imagine you invest £100 and you know the rate of return will be 10% over one year. At the end of year one you will have £110.That is based on £100 x 110% where the 100% is what you started out with and the 10% is the rate of return on your investment.
However if you then keep that money invested and earn another 10% in year two, you will not have earned an extra £10, but in fact an extra £11. That is based on £110 x 110% because you have £110 at the end of year one that earns 110% over the course of year two, this gives you £11 rather than £10 in year two.
Play this out over a five year period and the returns soon start to add up:
£100 x 110% =£110
£110 x 110% =£121
£121 x 110% =£133.10
£133.10 x 110% = £146.41
£146.41 x 110% = £161.05
So in just five years instead of earning £10 each year on your £100, i.e. £50 in total, you actually end up with £61.05 thanks to the power of compounding. That is, the rate of return applies to your original investment plus the previous year’s earnings to compound its returns year on year.
The average yearly earning over the five years in the example above will therefore work out to be £12.21 rather than £10. That’s amazing.
More importantly for investments and saving, what that should tell you is that the sooner you start saving and investing then the sooner you will start to benefit from compounding. As you will notice from the example above the increase in returns gets bigger with each passing year. So the sooner you start the sooner you get to those later years that generate higher returns.