The magic of financial compounding – and how it can help you gain financial independence

by Sukhi Arora

The reason behind why your parents or your financial advisor may say that the best thing you can do for your financial future is start saving early is not just because they want to be a killjoy over your continuous partying or spending sprees today.

There’s a fundamental key to it all, and this key is necessary to incubate your financial independence with the minimum effort on your part.

The hard work is done by the 4th dimension: time.

In finance, the more time an asset, say £10,000, is in the stock market or even more simply in a fixed rate deposit account, the more powerful the effect of compounding becomes.

The output for you is the original sum will grow and deliver to you an ever increasingly larger sum each time period it’s left alone. This means you end up with more money for doing nothing – in fact, for forgetting about the saving altogether.

Let us take an example. Suppose you have £10,000 which you put in a fixed interest rate bond paying 5% per year for 20 years.

If you were asked how much might that earn in interest over the 10 years, you may be tempted to quickly calculate that as follows:

5% of £10,000 = £500. So for 20 years, that’s £10,000 (£500 x 20 years).

So at the end of the 20 years, you would have £20,000

And that would be correct if you took out and spent the annual £500 of interest but left the original £10,000 sitting there.

However, if you left the £10,000 alone for 20 years with the annual interest to be reinvested in the bond and not taken out for spending, at the end of 20 years, you would have:

10000 * (1.05^10) = £26,533

That’s nearly 1/3rd (33%) more than the what is called the “simple” interest rate return calculation.

The longer the money is left the bigger the impact of the mathematical compounding will be.

Let’s just take the above example a do a quick comparison between the simple interest calculation which if you put in a fixed bond 10 years ago would generate £20,000 for you today, to putting the £10,000 into the something that generated on average about 7% per year. Over the last 20 years, that would be the US stock market (S&P 500).

Today, had you left the money to sit in the S&P 500, you would now have £38,835

(And by the way, that average 7% over the last 20 years was achieved despite the Asian financial crisis, the dotcom crash and the great financial crisis which all occurred in the last 20 years)

So now you can see the impact of compounding with a rate of about 7%. Had you put the money in the stock market you would have nearly doubled what you would have if you put it in a 5% fixed bond and spent the yearly interest.

And this is why if you start saving when you are younger, your savings, however small they may seem at the time, will have the chance to grow themselves over time. This is what’s behind the advice from your parents or financial planner/advisor. You can then have an even bigger party later too, if you like.

Underlying this effect is mathematics. Albert Einstein is quoted as saying “Compound interest is the eighth wonder of the world. He who understands it, earns it… he who doesn’t… pays it.”