You might have heard of ‘compounding returns’ or ‘compounding interest’ but what exactly does it mean? ‘Compounding’ in this sense means getting a return on your investment to increase its total value, and then getting another return on that. This ‘compounding’ effect increases the total value of your investment even more.
So, £100 invested receives 10% interest over one year, thereby growing to £110. The next year it’s £110 receiving 10%, thereby growing to £121.0. If the same thing kept happening over the next three years the investment would grow to £133.1, then £146.4, then £161.1. This happens because the returns remain invested – so they compound.
Compounding like this can be so powerful because this effect – in theory – could be exponential. Even Albert Einstein is alleged to have noted that “compound interest is the most powerful force in the universe”.
It’s always worth remembering, when investing, that the value of investments and the income from them can fall as well as rise and you may not get back what you put in. You should also continue to hold cash for your short-term needs.
Compounding in practice
In real life, you are unlikely to get 10% returns every year on any investment. For example, although equities (shares) have historically been shown to be one of the best performing asset classes, the returns they provide can be volatile – meaning they can be large some years and smaller other years or even make a loss.
But this is why compounding returns are so valuable to investors, says Coutts Chief Investment Officer Alan Higgins.
“Over time, compounding your returns by simply leaving them invested could help you ride through any market volatility,” he says. “In time this means you could realise total returns that could be much more than the total initial amount you’ve invested.”
We can see this by looking at the FTSE 100 stock market.
Between 31.01.2012 and 31.01.2022, the total FTSE 100 return was an average annualised 6.75% – but this is an average figure, in reality, some years saw higher returns and some years saw lower returns. By leaving your investment in the market it’s possible to see through the shorter-term volatility year to year and see your returns compound. If you had done this, you could have realised gains of 92.2% according to research done by Coutts/Bloomberg.
If we go back to period between 2002 and 2007, research done by Coutts and Bloomberg in May 2023 shows the FTSE 100 returned an annual average of 14%. By leaving those returns to compound over that five-year period, your investment could have grow by 95%.
And, if you reinvested any dividends you got from your shares you could see even greater returns from compounding over time. The below chart shows that happening between December 2001 and December 2021. Here you can also see the dips in the market from events such as the financial crash (2008) and the Covid pandemic (2020) – by staying in the market you can ride past these and see greater returns.
HOW COMPOUNDING CAN GROW INVESTMENTS
going longer for better compounding
“Investing for the long term is always the best strategy,” says Alan. “Historical data shows you are more likely to minimise your risk over the long term as you’ll be more exposed to the big gains the market might make over time. By staying invested for as long as possible you’re also leaving any returns in there to compound over time – and that’s when we see the biggest gains for investors.”
If you had invested for 20 years in the FTSE 100 between the end of 2001 and the end of 2021 you would have seen a rise of 193.34% on your investment thanks to compounding price returns and dividends, according to the paper Reinvesting dividends: the power of compound interest from FAS, published in October 2021.
HOW COMPOUNDED RETURNS CAN GIVE GREATER VALUE THAN CASH OVER TIME
Past performance should not be taken as a guide to future performance. The value of investments, and the income you get from them, can fall as well as rise and you may not get back what you put in. You should continue to hold cash for your short term goals.