From little acorns grow giant oaks

Posted by Liz Rees in Latest insights category on 20 Jun 19

The concept of compounding is one of the most important principles for investors to get to grips with. This is because it demonstrates how starting your investment journey as early as possible, even with small regular contributions, can have a significant impact on your future wealth.

Doing the sums

Let’s start with a question. If you were given the choice of £1m to spend right now or 1p to be doubled every day for 31 days, which would you go for? My first inclination, and that of most of my colleagues I asked, was to snap up the tempting offer of £1m.

In fact, if you take the penny and double it each day, by the 31st day it has turned into an astonishing £10.7m. That’s in spite of it reaching just under £10,500 after 3 weeks, and not breaking the £1m mark until day 28!

This example illustrates two things. The first is the psychological trait by which most people tend to value something in the here-and-now more than a future promise. The second is the mathematics of compounding, be it of interest, dividends or capital.

The investor’s friend

While the above may be an extreme case, the compounding principle is just as applicable to your investments. Over time, growth is added not just to your original investment but to the accumulated capital and reinvested income. This creates a snowball effect with the impact being gradually magnified over the years.

If your savings are in cash, any interest rolled up will also accrue the benefit of compounding, although if you withdraw it the impact is lost because the original capital remains the same. With equity-based investments, however, you can take your income in the form of dividends and there is still the opportunity for any capital growth to compound.

Some of the return on your capital is generated when companies plough back a chunk of their profits, after any dividends are paid out, into business expansion and development. This, in turn, can produce more revenues and profits. Most companies try to invest for the long-term regardless of day-to-day geopolitical events.

Although a major upheaval, such as Brexit, may delay the plans of some industries, structural growth themes are likely to persist regardless. It is generally the remit of fund managers to allocate capital towards companies with the best growth prospects and away from those in secular decline.

Reinvesting dividends pays dividends

If you are in a position to re-invest dividends, you get an additional potential boost to your investment returns. When you see the performance of a stock market index quoted in the press this usually excludes dividends which would provide a considerable uplift. Indeed, it is sometimes claimed they make up the biggest proportion of long-term returns.

To take an example, excluding charges a £100 investment in the FTSE All Share, which currently yields around 4%, over the 10 years to the end of May 2019 would be worth a respectable £174.19, yet add in dividends and the total return is a far more impressive £249.39.

Of course, stock markets do fluctuate and a downturn in some years is to be expected. However, many companies which pay dividends continue to do so in more difficult times, even if they maintain rather than grow them.

It works both ways

Albert Einstein is reputed to have said: ‘Compound interest is the eighth wonder of the world and the most powerful force in the universe. He who understands it, earns...he who doesn’t, pays it’.

Whether these were his actual words or not, they deliver the message perfectly and remind us of the other side to compounding. I’m sure we have all heard stories of how credit card debt can quickly escalate out of control, so it’s important to let it work to your advantage.

Start early and stay invested

We’ve seen that the beauty of compounding means that even modest sums invested early on are well placed to accumulate substantial returns over a lifetime. Therefore, it should pay to remain invested and not withdraw income any earlier than you need to. That’s not to say you don’t need to monitor and review your holdings regularly. Our goals, and attitude to risk, are likely to change throughout our lives so it’s important we re-position our portfolios to reflect this.

Having a higher exposure to shares, rather than bonds, may help overcome the risk of inflation eating into your returns although volatility is likely to be greater in the short term. This is why workplace pension schemes tend to have default investment strategies for younger members which are predominantly equity based, as they have all their working life to ride out any volatility. A SIPP is also a good way to exploit the benefits of compounding as you get tax relief to boost your investment. You can start a Willis Owen SIPP with a monthly contribution of just £25.

Similarly, equity funds have, in the past, demonstrated the greatest potential to produce inflation-beating growth over the long-term. One with a solid record is Threadneedle UK Equity Income which has delivered an annualised capital return of 6.2% and an annualised total return of 10.7%, over the decade to the end of May 2019, compared with annual Consumer Price Inflation of 2.2%. Nevertheless, remember that past performance is no guarantee of future success.

In summary, the cumulative effect of building on incremental gains is often under-appreciated. Well-managed active funds, give investors the opportunity to gain exposure to carefully selected companies with superior prospects for both capital and dividend growth. Compounding represents the reward for patience; ignoring the short-term stock market noise and letting businesses get on with what they do best.