There is an excellent article at the Motley Fool site entitled ‘The Miracle of Compound Returns’. In my view the impact of compound returns should be the first lesson taught at school because young people can make the concept work in the favour because they have time on their sides.
There are many people who use compounding returns to build a fortune – for example, many property investors have made fortunes by re-investing their rents and property gains over the last 14 years and in network marketing the compounding effect of new distributors and customers can rapidly make you rich.
In the Motley Fool article, they set out 5 foolish laws of compounding, to which I have added a 6th renegade rule. The rules are as follows:
- Start early i.e. the longer you can let the rule work for you the better. This is illustrated by the fact that it is better to save £100 per month from age 20 to 29 than invest £100 per month for the next 30 years if you are looking for a return at age 60.
- Small differences in return matter a lot. This rule is illustrated if you calculate the difference in return between say 7% and 8% invested over 40 years. At 7%, savings of £100 per month would grow to £248,552 and at 8% the figure is £324,180. That’s a difference of £75,628 for a 1% difference in interest – that’s a lot of money given that your initial investment is just £48,000 in both scenarios.
- Don’t squander your inheritance (unless you want to!) This makes the point that you probably need to strike a balance between enjoying yourself now and investing for your future.
- Over time, regular saving of quite small amounts can build your fortune. This rule is illustrated by saving £100 per month over 40 years at 12% would yield £980,000 – not far short of £1m! With base rates currently at 0.5% you may feel that such a return is impossible but bear in mind that Warren Buffett has generated an average return of 23% from his investments over many years. Hence the reason that he is a multi-billionaire.
- Time and patience are the friends of compounding and investing. You need to re-invest your interest and dividends to make the principle work.
- Compounding cuts both ways. (This is the sixth rule added by me!) In other words, the principle of compounding can destroy your wealth as quickly as it can build your wealth. Take the example of credit cards, some banks charge in excess of 25% interest. If you calculate the amount of profit a bank can generate at this rate of return, no wonder they want us to borrow this way. (If you think the bank is interested in your financial welfare, then the fact that they push this product at their customers gives the lie to their advertising!)
If you would like to read the Motley Fool article then click here or if you want to get compounding returns from network marketing, then look at this ‘What’s it all about? ‘ video. Alternatively, if you need to get out of debt fast, then read this article.