Crazy Rich Compounders

Are you ready to become crazy rich? No, I’m not talking about robbing a bank or winning the lottery. I’m talking about the power of compounding.

Let’s start with a question – how much would you have if you made a 10%/year return on £10,000 for 30 years? Go ahead, make a guess – we’ll come back to the answer shortly.

Before we get there, let’s explore compounding.

CRAZY RICH COMPOUNDERS

It’s easy to look at wealthy people and ask how they earned their money. There will be many answers, but among them will be a common thread – compounding.

Compounding is the process by which interest is earned on a greater sum of money in each period. For example, if you start with £1,000 and earn 10%/year, then after one year you’ll have £1,100 (a £100 gain). If you earn 10% again the following year, you’ll have a £110 gain, because your principal amount is larger in year two. This process, continued over time, leads to exponential gains.

Compounding is often labelled the eighth wonder of the world, and for good reason. It’s the force than can turn a small investment into a fortune over time. And the best part? You don’t need to be a mathematical genius to understand it. All you need is patience and discipline.

At the beginning of your investment journey, the amount you save is most important. If you start with £1,000, the question of whether your return is 5%/year or 10%/year matters far less than your ability to save an extra £1,000. That extra £1,000 saved is equivalent to a 100% gain.

But if you have £10,000,000 in investments (a nice problem to have…), that extra 5%/year return is worth much more than an extra £1,000 saved. Over time, your rate of return becomes more important than how much you save.

Combining both good savings and a good rate of return is a recipe for financial success, especially when over a long time-horizon. That’s where the magic happens.

THE NUMBERS

Let’s look at the numbers in the table below, showing what happens to an initial £10,000 under different combinations of return and time:

First things first – what was your guess for a 10%/year return on £10,000 for thirty years? The answer was £174,000. Pat yourself on the back if you were in the ballpark, but I’d guess you hadn’t imagined such a big number…

Let’s read through the table. Starting with the 5%/year growth, your £10,000 grows substantially in a decade, by over 60% to £16,000. But the next decade, that 60% growth takes you from £16k to £26.5k. The gain you make in the second decade is more than what you started with! And by the time you get to forty years in, you have 7x what you started with. This is serious growth. If you had left the £10,000 in a non-interest paying bank account, it would still be worth £10,000.

The takeaway here is that it matters much more what you do with your money than how much you have to begin with.

Moving to the 10%/year column, you’ll have substantially more after ten years than with a 5%/year. But it’s after thirty and forty years that you see the real difference. And of course that difference is magnified when you get to a 15% or 20%/year return. The numbers are, quite frankly, crazy, given you only started with £10,000.

Remember that the table above assumes an initial £10,000 - it doesn't account for additional savings each month. With those added, the numbers will be far greater.

Impressive, right? But here’s the kicker. Most of your returns come right at the end of your investment period. Looking at the 10%/year scenario, 63% of your gains come in the last ten years. For the 20%/year scenario, that figure is 84%!

So it’s not just your rate of return that counts, but how long you can continue to make good returns, without doing something stupid or wasting your money. The longer you let your money compound, the more exponential growth you’ll see. It’s the first rule of compounding: don’t interrupt your growth unnecessarily.

WHY IT’S SO HARD

I know, I know. No one wants to wait forty years to become rich. But those who do will reap the greatest rewards. If it were easy, everyone would do it. It’s worth doing precisely because it’s hard, and because it will put you on the path to financial freedom.

That doesn’t mean being a miser – don’t do that. But plot a sensible course and compounding will work wonders.

It’s usually our psychology which impedes us in this process. For one there’s the temptation to time the market. It’s easy to get caught up in the frenzy of buying low and selling high, but in reality, it’s nearly impossible to consistently time the market. Instead, it’s better to focus on time in the market, as shown by our table above. That way, you’ll benefit from the magic of compounding over time.

Finally, volatility throws a spanner in the works and plays with our mind. It’s not all sunshine and roses. The 10%/year scenario may actually be 30% up one year, 30% down the next, 80% up the next, and 10% down the following year. Sometimes, this means we can’t see the bigger picture. When markets are up, we feel trees will grow to the sky, and when markets are down, we feel they will never recover. Neither is a sensible assumption – it’s only with a long-term lens that we can see through the noise and focus on the benefit down the line.

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Ultimately, the best way to benefit from compounding is to keep things simple. Save well and early. Invest your savings, preferably in a diversified set of companies (perhaps via index funds or ETFs). Keep contributing regularly to your savings. Use tax-efficient wrappers like ISAs and pensions. Don’t withdraw money unnecessarily. Avoid lifestyle creep. And let compounding do its thing over time.

Looking forward, it seems a murky path. Looking back, it will be clear as day. Compounding is magic - use it to make money work for you.