Compounding in a nutshell

Important information - investment values and income from investments can go down as well as up, so you may get back less than you invest.

• The blue line shows what would happen to £100 if you simply left it under the mattress for 50 years. By the end of the period, it would still be worth £100.
• The orange line illustrates what would happen if you earned a 5% return on your £100 and took the interest earned out of your account each year and stashed it under your mattress. Each year you would earn another 5% on your £100 of capital. The line shows the combined value of all the accumulated interest earned and your starting capital. By the end of the period, you would have amassed £350. That’s £100 of capital plus £5 a year for 50 years, or £250. Of course, if you spent all the interest, you would also have just the £100 initial capital left at the end, as with the blue line.
• The green line shows the powerful impact of compounding. Again, you earn 5% a year, but this time it is applied to both your capital and to all the previous years’ interest as well. As you can see, the benefit increases year by year. At the end of the 50-year period, you will have a total of £1,147, more than eleven times your starting capital.

It's worth noting that by the end of the period, you are earning a return of more than £50 a year. That’s more than 50% of your original capital - every year!

Investment compounding vs savings compound interest

What we have described so far is compound interest. This is what happens in a savings account.

Investment compounding is potentially even more powerful than compound interest because it has two elements:

• Capital growth (the potentially rising value of shares, for example)
• Income from dividends (or interest from bonds)

In an investment portfolio, compounding works in a similar way as with compound interest on cash savings. The reinvestment of dividend income (or the coupons on a bond) - by buying more units, shares or bonds - is the equivalent of adding last year’s interest to the capital in the compound interest example.

In the context of an investment fund, this reinvestment can happen automatically if you invest in an ‘accumulation’ share class. Otherwise, if income is paid out from an ‘income’ share class, it is possible to reinvest it manually to achieve the same effect.

Technically, the reinvestment of dividends via an accumulation unit is not an example of compounding but rather the ‘dividend value’ is added to the existing units’ value and so has a similar effect.

It is the combination of this reinvested income with any capital growth achieved that can magnify the impact of investment compounding. It is not simply that your investments are powered by two separate engines. Each one makes the other one more efficient. That’s because:

• Reinvested dividends increase the capital you have to grow in future
• More capital increases the level of dividends you will receive year after year

Comparing apples with apples

You should bear in mind that the capital in a bank savings account is secure. The value of investments, by contrast, can fluctuate. They can fall as well as rise. This absence of certainty when investing, however, brings greater opportunity.

There are no guarantees, of course, because neither capital growth nor the payment of dividends can be relied on. Some years, the value of shares might fall, or a company may decide not to pay a dividend. Historically, the combination of growth and reinvested dividends has delivered much higher returns from stock market investments than from cash savings. But these higher returns come with a risk of loss that is not present with cash.

The importance of time

Time is the real engine of investment compounding.

In the early years, you might be underwhelmed by the growth of your portfolio. Most of the growth of your investments is still coming from your own contributions.

However, as time passes, you will most likely reach a tipping point.

• Investment returns start to become a more significant contributor to total returns than your savings
• The upward curve of the value of your accumulated capital steepens (similar to the effect illustrated in the compound interest chart above)

This is why it is so important to start saving and investing early. Time is the magic ingredient in compounding.

The importance of reinvesting dividends

Just as important as time is keeping all your money working hard for you.

• If dividends are taken as income, compounding ceases. You are then reliant solely on a change in the capital value of your investments for any growth
• When dividends are reinvested, any capital growth will be magnified and any capital losses can be offset

Reinvested dividends:

• Buy more shares or units
• These new units generate their own dividends, which increase the total value of future dividend payments
• This can create a feedback loop of growing income and capital

Historically, a large proportion of the long-term returns from stock markets has come from reinvested income rather than price growth alone.