The importance of compounding returns

We have talked about it a few times, so you will now be familiar with the term, but what exactly does ‘compounding returns’ or ‘compounding interest’ mean?

‘Compounding’ in this sense means getting a return on your investment to increase its total value, and then getting another return on that return. This ‘compounding’ effect increases the total value of your investment even more and the longer you are invested, the greater the impact.

The way compounding works on your investments is relatively simple. In the first year of investing, you may generate modest returns on the initial capital. Without withdrawing that money and leaving it invested, in the second year, you would have invested the original capital plus the returns you may have got from year one.

Imagine this being repeated over several years (though you are unlikely to get positive market returns every single year) and so you unleash the potential to generate further returns on the total. Ands o, it goes on, helping you to build a bigger pot.

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So, £100 invested receives 10% interest over one year, thereby growing to £110. The next year it’s £110 receiving 10%, thereby growing to £121.0. If the same thing kept happening over the next three years the investment would grow to £133.1, then £146.4, then £161.1. This happens because the returns remain invested – so they compound.

Compounding like this can be so powerful because this effect, in theory, is exponential. Even Albert Einstein is alleged to have noted that “compound interest is the most powerful force in the universe”.

In real life, you are unlikely to get 10% returns every year on any investment. For example, although equities (shares) have historically been shown to be one of the best performing asset classes, the returns they provide can be volatile, meaning they can be large some years and smaller other years or even make a loss, it happens.

No investment is ever guaranteed; you can be subject to the ups and downs of markets. Be very wary of anyone who tells you otherwise.

You may not achieve positive returns every year, although the probability of losing money has been historically proven to fall the longer you stay invested.

Patience is key to allowing compounding to work its magic over time, and if you stay invested over a longer term, you are givingy our investments a better chance to make up for any short-term losses.

This is why compounding returns are so valuable to investors, says Coutts Chief Investment Officer Alan Higgins.

“Over time, compounding your returns by simply leaving them invested could help you ride through any market volatility,” he says. “In time this means you could realise total returns that could be much more than the total initial amount you’ve invested.”

“Investing for the long term is always the best strategy. Historical data shows you are more likely to minimise your risk over the long term as you’ll be more exposed to the big gains the market might make over time. By staying invested for as long as possible you’re also leaving any returns in there to compound over time – and that’s when we see the biggest gains for investors.”

If you had invested for 20 years in the FTSE 100 between the end of 2001 and the end of 2021 you would have seen a rise of 193.34% on your investment thanks to compounding price returns and dividends.

_{Source: Reinvesting dividends: the power of compound interest from FAS, published in October 2021.)}

At TPP returns are always reinvested. This is automatic, you don’t need to do anything. As the strategy capital grows, the traders will increase the size of the trades to match the increase in the investment.

Our portfolios are fully automated using our autotrade software.

So, now that we understand compounding, let’s look at a few examples of different funds and just how much difference performance can make over time with the inclusion of compounding returns.

Here we can see comparisons between some of the most well known funds in the UK and their comparative performances. We have taken performance from the same sector: Global equities.

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Let’s look at exactly what this would mean if you invested with an initial deposit of £100,000.

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Returns over one year don’t always seem important, and we can easily ignore them. But nobody invests in a portfolio for one year. Investment portfolios are designed to be held over as long a time frame as possible to allow the returns to compound.

The longer the money is in the market compounding returns, the faster your portfolio should grow. Of course, the value of your investment can go down as well as up, but the longer you are invested in the market, the less volatility you should experience and the more you are likely to average a solid return.

There will be good years, and there will be bad years, but given time, every percentage point is key to your future wealth.

The difference between the worst performing fund in the graph (SJP’s Global Equity Fund) and the FTSE World Index is 5.9% annualised over 10 years. It’s a lot but it’s not a number that would necessarily concern you. However, the difference in percentage terms at the end of the 10 years to your portfolio is 138.3% or £138,300 on the initial £100,000.

Don’t just accept mediocrity, it’s your own wealth you’re sacrificing.

At TPP we run leverage equity index products. This means that over time, our leverage trackers will magnify profits (and short-term losses, but historically equity markets have only grown given enough time). Our performance could mean that the 233.3% made by the FTSE World Index would equate to around 349.95% on our TPP tracker equivalent.

This would mean the £100,000 would be worth £449,950 after the same 10 years.

The down years will obviously also be increased, it would be irresponsible not to point that out, but so will the best years and that is where the gains are really made. Given enough time, historical data shows that the market will grow your portfolio, so why settle for average, or even 1:1 returns, when you can get 1.5:1 with TPP.

For more information, please contact us.

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