Compounding the situation

September 4th, 2010

A question that is often asked is ‘when is it best to invest?’ Many people will have their own answers such as:

  • ‘When the market is low’
  • ‘When there is stability in the markets’
  • ‘Only on a drip feed basis to reduce risk’
  • ‘Only when you can afford to’
  • ‘When the market is rising’
  • ‘When the market is falling’

There is nothing to say that any of these are wrong but how right they are depends upon the individual’s personal circumstances such as their appetite for risk, affordability, financial requirements & term of investment

So where does this leave us in relation to the question? Well, the one aspect that applies to all circumstances is to invest as early as you can afford – the main reasoning behind this is the effect of compound growth/interest.  Time can be an important factor in the eventual returns you can get, dependent upon when you invest.

There are 2 main types of growth/interest described as follows

Simple –     this is interest or growth based on the original sum invested only each and every period.
Compound – this is interest or growth based on the original sum and previously attributed interest/growth.

Therefore, compounding growth/interest will provide a greater return than the simple variant as you will get growth on previous growth/interest as well.

It does need to be remembered, however, that growth or interest rates are not always guaranteed to remain level, or to beat inflation (if it does not then the purchasing value of your money will fall) and in respect of growth, this can actually be negative.

Imagine the following situation – you have twins both looking to have a lump sum when they reach the age of sixty.  The first twin (A) starts work not long after leaving high school and invests £1,000 per year for ten years until he finds other needs for his spare income.  The second twin (B) goes to university and cannot afford to start saving until ten years after her brother started, but continues until age 60.

They both invest in exactly the same investment vehicle and receive annual growth of 7% per year. The surprising results can be seen in the table below:

Twin A Twin B
Age invested Amount invested accumulated amount* Amount invested accumulated amount*
16 £   1,000.00 £      1,070.00
17 £   1,000.00 £      2,214.90
18 £   1,000.00 £      3,439.94
19 £   1,000.00 £      4,750.74
20 £   1,000.00 £      6,153.29
21 £   1,000.00 £      7,654.02
22 £   1,000.00 £      9,259.80
23 £   1,000.00 £    10,977.99
24 £   1,000.00 £    12,816.45
25 £   1,000.00 £    14,783.60
26 £    15,818.45 £  1,000.00 £    1,070.00
27 £    16,925.74 £  1,000.00 £    2,214.90
58 £  137,862.09 £  1,000.00 £127,258.76
59 £  147,512.43 £  1,000.00 £137,236.88
totals £ 10,000.00 £  157,838.30 £ 34,000.00 £146,843.46

*includes compounding growth.  Example is for illustrative purposes only and does not represent the past performance of a particular investment

By investing 10 years earlier Twin A has a larger lump sum at age 60 even though he has only invested £10,000 compared to Twin B’s £34,000.

To further emphasise the benefit of compounding growth – if instead Twin A had received only simple growth of 7% then at age 60 the final figure would have been a mere £38,350.

Investing early can reap greater rewards at a lower cost (although inflation will erode the value).

But remember that the situation also works in reverse – if you are paying compound interest on an amount borrowed (such as with a mortgage) the longer the loan the greater the cost.

The value of investments may fall as well as rise and you may not get back the full amount invested