The power of now, why there’s no time like the present

By Tom Stevenson, 21 August 2008

In this week’s column, Tom Stevenson explains the magical power of compounding Some of the greatest minds in the world have marvelled over a simple, but extraordinarily forceful concept – the wonderful power of compounding.

Wrapped up in this amazing mathematical fact is the answer to one of Britain’s most pressing social problems, the pensions time-bomb.

Einstein called it “the greatest mathematical discovery of all time” and “the eighth wonder of the world”. The economist John Maynard Keynes described the “awesome power of compound interest”.

What amazed these great men was the way in which, given enough time, even apparently trivial amounts of money can turn into spectacular fortunes.

If we were to take the trouble to explain the power of compounding to every school-child in the country, there would be no savings gap and we would not be worrying about working into our seventies.

I did just that recently. On a country walk with a young family friend – Alice is 18 years old and just heading off to university - I happily explained this simple but profound concept (well she did ask!). This is what I said:

“Imagine you have £1,000,” I said. “And that, by investing it wisely, you are able to grow it by 10% in a year; at the end of that year you will have £1,100”

"Do the same for a second year and you will have not £1,200 but £1,210 because your 10pc return on the starting £1,100 is worth £110. Do this every year for 20 years and the return in the last year will be £600 and the initial £1,000 will have become £6,700.

"Now imagine that during the first year you put aside another £1,000 (it's only £20 a week) and at the end of the year you set it to work alongside the first £1,000. The 19 years during which it too grows at 10pc a year will turn it into £6,100. The third year's regular savings of £1,000 will grow to around £5,600 in 18 years and so on.

"In 20 years' time, when you are just turning 38, you will have amassed £63,000 by simply saving £20 a week and achieving a good but far from unrealistic return. By then, adding £1,000 a year to your savings will be nearly irrelevant and you will be able to stop saving altogether.

“That’s because when you are 40, the 10pc return on your pension pot will be worth more than £7,000. By the time you are 50 it will be growing at about £20,000 a year and by the time you are 60 you will have a nest-egg worth well over £500,000.

"The beauty of compound interest is that the longer you can let it work its magic the greater the rewards. Although it will take you a little over 30 years to build up half a million of savings, by the time you are 68, which is the age the rest of us are told we'll now have to work to, you will have more than doubled your money again to £1.2m, quite enough for a comfortable retirement and all for £20 a week."

"But," said Alice, "my twin sister Camilla says 'forget the pension, I've a hundred and one better things to do with my money'."

"Of course she has," I said, "and she will doubtless spend the next 20 years doing what most of us do in our twenties and thirties. She will enjoy herself and then get married and find a hundred and one new calls on her cash. There's always something.

"Unfortunately, she will also realise on her 38th birthday that she has nothing to show for the £80 a month she has spent without noticing, while you have £63,000 and have stopped worrying.

"Belatedly Camilla will then follow your good example and start putting aside £1,000 a year. Unlike you, however, she won't ever be able to stop saving because she will be running hard to try and join you. She never will. However long she continues to save she will never catch you up.

"By the time Camilla is 60, despite saving for a couple of years longer than you did, she will have amassed £87,000, around a sixth as much as you.

"Over the next eight years, while your retirement pot grows to £1.2m, hers will rise to just £200,000 and she won't get many cruises from the income on that."

“Two questions” said Alice, who may not have been taught anything much about money but who can spot the flaw in an otherwise perfect argument. “How do I earn 10% a year on my savings and where do I find £20 a week?”

“Good questions” I said, “but those will have to wait for another walk”.

The value of the fund and the income from it can go down as well as up so you may get back less than you invested. The ideas and conclusions in Tom Stevenson’s weekly column are his own and do not reflect the views of Fidelity’s portfolio managers. They are for general interest only and should not be taken as investment advice or as an invitation to buy or sell a specific security.

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