The power of compound interest gestaltz electricity and magnetism review game

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Compound interest is a simple concept but the significance is not widely understood. An exercise that I carried out for one of my offspring may have wider value. Assume you save £200 in an ISA for 35 years. Assume two possible rates of return, 5% and 10% and two possible fee structures, 0.21% and 1%.

The lesson is that saving even relatively small amounts in low-cost vehicles can have a huge impact. Moreover taking slightly riskier but potentially higher returning investments has a disproportionate effect on terminal wealth. If you save in cash and get 2% (zero fee) over this period you will end up with £121,509. Over 35 years it pays to take some risk. If you wish to play around with the numbers (and check mine) I used this calculator and deducted the assumed fee from the return.

What kind of return can you expect from the FTSE 100 over 35 years. The answer is no one knows. Historical studies (1900-2017) suggest UK equities return around 5.5% real so with inflation averaging 2.5% that gives a nominal return of 8%. However does 35 years constitute the long-term? Looking at sub-periods one gets quite different outcomes, some better and some worse.

A different way of looking at this is to note that total return figures include dividends being reinvested continuously. This enhances the compounding effect. The FTSE 100 is presently yielding close to 4%. It consists of rather solid but unexciting stocks and it is not really a UK INC investment. The bulk of earnings are generated in foreign lands so it is like owning foreign indices . However it lacks the excitement of high-tech stocks and contains a few dying industries (tobacco, oil). It also has a number of battered banks and financials in the selection. The last 18 years have been tough for the FTSE 100 but it has still produced a positive return for a sensible investor. If you had invested £1000 31/12/1999 and reinvested dividends you would now have £2193, a compound annual return of 4.6%. Not amazing but considering the nature of the period, respectable. Your £200 pm would also have compounded at 4.6% over this period.

For the adventurous investor more diversification into overseas indices makes sense or maybe more UK stocks, so go for FTSE All Share index. The principles remain the same. The appeal of the FTSE 100 is simplicity and cost. Vanguard offer a FTSE 100 tracker unit trust that charges 0.06% and a platform fee of 0.15%. Not sure it comes any cheaper.

The key is consistency. Pick a regular investment level that you can commit to for 30-40 years. It does not matter how small it seems now because you can always adjust up as income grows. Moreover compounding may surprise you. It is better to save something than nothing (unless of course you aim is to throw yorself at the mercy of the welfare state). The trick is to keep investing something. It may be through an ISA or pension plan (the latter has tax relief and employer contributions, so even better). Set up the direct debit, choose the accumulation fund version, and then check it again in 30-40 years. You may be surprised.