Tuesday 5 March 2013

Start Early - Compound Returns

In my ebook “DIY Pensions”, I described the situation of two people, Alex and Sue. Sue started paying £2,000 per month into her pension from age 25 yrs and continued for 10 years. Alex started paying the same amount 10 years later than Sue and continued for 30 years. Sue paid in a total of £20,000 and Alex a total of £60,000. At retirement, Sue’s pension pot was £100,000 more than Alex’s!

The dramatic effects of this outperformance of Sue's fund are entirely due to the magic of compounding returns over a longer period - with a pension or investment, it will be the compounding of reinvested dividends - with cash savings, it is the effect of compounding interest on previous years interest.

So, whether you are saving in a pension or a stocks and shares isa or a cash isa, the principle is the same - the sooner you can start saving, the more time your money will have to compound and grow.

Albert Einstein described compound interest as "the greatest mathematical discovery of all time". For Homer Simpson, the greatest discovery would be "Beer, the cause of, and solution to, all of life's problems".

There are basically just two elements to compound returns -

Time, and

Rate of Growth

Here’s a simple spreadsheet setting out the compound returns on savings of £50 per month over various periods ranging from 10 years up to 50 years. The rate of 2.5% roughly equates to current average cash deposits, 5% roughly equates to long term returns on equities without reinvesting dividends and the final figure of 9% is for long term returns on equities with dividends reinvested (allowing for minimal charges).

10 Yrs             6,812        7,750         9,554
20 Yrs           15,533      20,372       32,172
30 Yrs           26,696      40,934       85,717
40 Yrs           40,986      74,427     212,477
50 Yrs           59,278    128,983     512,562
                               (£50 per month is £600 p.a. and £6,000 over 10 years)

As you can see, seemingly small differences of 2% or 3% per year on the rate of return on savings or investments can make a huge difference to the final outcome. Equally, if you can save 1% or 2% on costs and charges in relation to investments, this will have the same effect.

So How Much Should I Save?

I have used the figure of £50 per month as an example but obviously each person will have different levels of income and expenditure - the harder you save and the earlier you start, the better the outcome. For equity income investors, assuming you do not require income to live off, it will definitely pay to reinvest the dividends. This extra recycling of the 3% or 4% will have the effect of turbo-charging your portfolio returns.

To play around with some figures of your own, I have used the calculator tools on the Candid Money website  here

So, in this mini series looking at my basics of investing, I have covered the importance of thinking long term, avoiding high charges, the role of dividends and now the effect of compound returns. In the next instalment I will take a look at understanding the volatility of the stockmarket.

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