Compounding is magic over the long term

If you don't understand compounding look at Interest first. Here we look at what compounding does for the investor.

Was Manhattan a good buy?
Every schoolboy knows that the Dutch bought the island of Manhattan from the American Indians for $24 in 1624. This story is usually told to invoke much guffawing at the financial innocence of the indigenous population.

In fact, if the land value of the whole of present day Manhattan is about $150 billion this represents a compound return over 386 years of just 6% per annum for the Dutch - not exactly an explosive return for a property investment. Advantage the locals, one feels.

If the same amount had been put into a property bond in 1624 at 5% per annum (1% less), how much do you think it would be worth in 2010? The answer is a lousy $3.6 billion, just 2.4% of the $150 billion it would have been worth at 6%.

The lesson is....
OK, stretching the investment period to 384 years rather over-dramatises the point, but the only two things you need to know about compound interest are in this example:

• Small amounts, given time, will compound into large amounts, and
• Small differences in return, over a long time, matter.

...and the numbers are.....
Investment of £1,000 a year for 40 years, compounded at 5%, will grow to £128,000.
Investment of £1,000 a year for 40 years, compounded at 6%, will grow to £165,000.
Investment of £1,000 a year for 40 years, compounded at 7%, will grow to £215,000.

So a return shortfall of 2% will cost you 40% of your savings.

This matters because....
.......you need to understand the effect of annual charges on financial products. Suppose you have decided to invest £1,000 a year in shares, and you have to chose between picking them yourself with the help of a friend and paying a professional manager 2% per annum to run your portfolio. Over 40 years the professional manager is going to take 40% of your portfolio. So you had better be sure that his skill is enough to compensate for that.

OK, so you don't have a professional manager. But when you buy a financial product you are committing to a whole load of extra annual costs that are going to drag on your investment returns unless they are creating wealth to compensate. Wealth for you, that is.

A final bit of maths
Surprisingly (we think) if you do the same maths for higher returns you get the same relative result - a 13% return (for example) accumulates to 40% less than a 15% return. So you may feel rich, but you have still given away 40%.