By: Tim Bennett
12.07.2018
12.07.2018
Too many investors miss out on the only free lunch they will ever get. Tim Bennett looks at why in this week’s short video.
Investing’s biggest tragedy
Compound returns, or the ability to earn “interest on interest” has been described as the eighth wonder of the world. So why do many people not take full advantage? I think there are three reasons – we are linear thinkers, we struggle to take a sufficiently long-term view and we pay a heavier price than we sometimes realise for giving up early.
Linear thinking
Our brains are actually not very good at thinking the way that compounding requires us to – geometrically (to give it a scientific name). For example, if I offer you 5% per year on £1,000 and ask you how much you will have after five years, you may be tempted to say £1,250 (£50 per year plus the original £1,000). The truth is you will have more than that because every time a return is added to your capital, it can earn a subsequent 5% too.
Over the long-term, this can really add up. The middle column here shows what £300 per month could become over 25 years at an illustrative 5% growth rate;
Whilst 5% is in no way guaranteed, the pink bar shows that the growth on top of the amount invested could double your money, especially if it is earned tax-free within a suitable wrapper such as an ISA or SIPP.
Short-termism
A further reason therefore why compounding doesn’t always seem to work is that people expect too much too soon. The power of earning interest on interest has been called a route to “get rich slowly”. 25 years may seem an eternity to a young person but many a 50 year-old will confirm otherwise. In a social media age of low attention spans and short time horizons we need to remember that wealth building takes time.
Not staying the course
The temptation to not wait is especially dangerous towards the end of any chosen growth period. That’s because a disproportionate percentage of your total gains come towards the end. This scenario below highlights the danger of cashing in early;
The last five years of this 25 year period earn you 31% of your total return. And you get a similar result with the monthly example – the amounts are just larger.
What all this tells us
In order to take proper advantage of one of investing’s only free lunches, we need to follow some basic rules. All are easier to say than do but they are critical to making compounding work for you.
