In fact, some of the world’s best-known long term investors owe much of their success to compounding.
Take Warren Buffett: his net worth is around $63 billion, $62.7 billion of which (95 per cent!) was added after his 50th birthday. That’s due, at least in part, to the effect of compound interest.
The kind of horizons we’re talking about here – 20 or 30 years – may seem very distant, but they’re actually quite realistic. Daniel Godfrey, formerly chief executive of the Investment Association, noted that “today, a 60-year-old might expect to still be saving for a few years yet and then to need their capital first to supplement and then to replace their earnings for another 20 years or more”.
A worked example
Imagine you put £100 each month into RateSetter’s five year market, and let’s assume, to keep things simple, that it consistently paid 5 per cent (in fact, the average return in this market at the time of writing is 5.9 per cent).
In the chart above, the bars – in blue and purple – are linked to the axis on the left hand side. They show how much you’re paying in each month (£100, in blue), and how much you’re earning in interest each month (an increasing amount, shown in purple).
The stacked grey areas show your total earnings. Dark grey is the money you’ve paid in, which increases by exactly £1,200 each year. The light grey shows the total interest you’ve earned, and increases at an exponential rate.
After a year, you’d have £1,233 in the account. £1,200 of that would be money you’d paid into the account of course, and £33 would be interest.
At the end of the fifth year, things still look pretty humdrum: you’d have £6,828 in your account, £6,000 of which is money you’d have paid in; meaning you’d have earned £828 in interest.
By year ten though, things are looking a little more interesting: you’d have put £12,000 away, and have earned a cool £4,592 in interest. Those interest payments are starting to add up, too: you’d be earning around £65 each month in interest.
Towards the end of year 14, your interest payments would top £100 each month, and continue to grow. That means that your money is essentially working harder than you are: you’re earning £100 each month without having to do anything for it.
As the timeline increases, so do the returns. By the end of year 30 you’d be earning £346 per month in interest alone, and, if you expanded the chart to year 40, this rockets up to £635. At that point, you’d have £152,000 squirrelled away, and the best part is that you’d have only paid in £48,000, with the remaining £105,000 made up of interest.
There are four main obstacles here: tax, inflation, fees and of course, risk of losing your capital due to the lack of cover from the Financial Services Compensation Scheme (FSCS).
Taxes and fees are pretty easy to factor in: RateSetter doesn’t charge fees for investment, and thanks to the Personal Savings Allowance and upcoming Innovative Finance ISA (IF ISA), most people will be able to invest without incurring tax on the returns.
Like all investments, RateSetter carries risk; specifically the risk that borrowers will not pay back. Investments are not covered by the FSCS, so we introduced the Provision Fund to provide protection for investors. The Provision Fund has a perfect track record to date, but that’s not a guarantee for future performance.
Lastly, the least obvious factor is inflation. Inflation doesn’t affect the nominal value of your investment – £100 today is still £100 tomorrow – but it does affect the purchasing power of your money, something referred to as its “real” value: if prices rise, as they tend to do, £100 would not buy you as much in a year’s time as it would today.
We’ve covered inflation (or rather its opposite, deflation) before, and although currently inflation sits close to 0%, if and when it rises, it will affect the purchasing power of your money, whether you invest it or not.
What all this shows is that by investing over long periods, you can earn great returns. If you’re anything like me, you’re probably reading this wishing you’d put more money away ten years ago, but hopefully this article will show you that there’s no time like the present to start investing.
The lesson here is that, with a little patience, even a modest investment can grow into something really quite impressive.