Want to put your money to work and potentially grow your finances? Investing might be a great way to develop your wealth since your invested money could benefit from the power of compounding and flourish over time.
Here’s how compounding (supposedly once described as ‘The most powerful force in the Universe’ by Albert Einstein) works.
The 'snowball' effect
When investing, dividends that are paid out and reinvested into a fund 'compound' year-on-year. This sounds pretty complicated, but it really isn't.
It basically just means that any money you make on top of your original investment is invested back into your portfolio, so it could make you more money in the long run.
Compounding in a favourable environment means your money could build up – a bit like a snowball rolling down a hill, getting exponentially bigger as it picks up more and more snow on its way down.
Here’s a hypothetical example to just explain how compounding works:
Say Sarah invests £7,000 and receives a dividend payment of 3% which is re-invested into the fund. At the end of year one, she would make a gain of £210 and her investment plan would be worth £7,210.
Sarah now has £7,210 invested, which returns a 3% dividend. This means that at the end of year two, she would make £216 and her Investment Plan would be worth £7,426.
Following this logic, Sarah's original £7,000 investment could be worth £10,906 after 15 years. It's as simple as that!
Please note that this is only an example to demonstrate how compounding works. It is not a reliable indicator of how much you could end up with if you invest.
‘How long’ not ‘how much’
Compounding and its effect on investing is more about ‘how long’ rather than ‘how much’.
These days, you don’t need to be wealthy to start investing – digital investing services, like Wealthify, let you open a Plan with a small amount. In fact, you can become an investor by opening a Stocks and Shares ISA, General Investment Account (GIA) or Junior ISA with us from as little as £1, and a Personal Pension from £50. Plus, we'll do all the investing for you so you don't need to have any knowledge of stock markets either.
With a Stocks and Shares ISA, you can invest up to £20,000 per year without paying tax on any gains your money makes, while a General Investment Account is for any investing you want to do outside of your yearly ISA allowance.
A Junior Stocks and Shares ISA, on the other hand, lets you invest up to £9,000 for your child per year (with the money being locked away until they're 18), while a Personal Pension (SIPP) could allow you to boost your retirement fund by paying into it alongside any workplace pensions you have.
However, if you want to take full advantage of compound returns, then it could be beneficial to start investing sooner rather than later.
As an example, if you put in £100 a month, you could end up with £14,853 after 10 years.1 However, if you kept the money invested for another five years, your return could be £24,399.2
You could put in a lump sum, or invest little and often. Then it’s a matter of sitting tight over the long-term (this is typically at least five years) to give you an opportunity to ride out market ups and downs, resisting the temptation to withdraw your funds if they dip in value, and letting compounding have a chance to potentially work its magic.
Please remember the value of your investments can go down as well as up, and you could get back less than invested.
Wealthify does not provide financial advice. Seek financial advice if you are unsure about investing.
The tax treatment depends on your individual circumstances and may be subject to change in future.
References:
- This is the projected value for a Confident Plan (Medium Risk Plan) with an Original theme. This is only a forecast and is not a reliable indicator of future performance. If markets perform worse, your return could be £12,440. If markets perform better, your return could be £17,827. Values correct as of 06/07/23.
- This is the projected value for a Confident Plan (Medium Risk Plan) with an Original theme. This is only a forecast and is not a reliable indicator of future performance. If markets perform worse, your return could be £19,312. If markets perform better, your return could be £30,377. Values correct as of 06/07/23.
