How does compound interest actually work on investments?

IAMIAM

Am I right in thinking its just shares, funds and bonds etc that are just increasing or decreasing in value, hence I don't understand where the compounding is happening? If something is £2 now and £20 in 10 years, the value of that £2 coin has gone up but where is the compound bit. 

I

MaxiRobriguez

Compounding is the impact of interest/investment gains over many years.

If you invested £2 now and you get a 10% annual return, then next year that £2 is worth £2.20.

The year after that it is worth £2.42, by year five it's £3.50, by year 10 it's £5.20 and after 20 year it's worth £13.50. You've done nothing to "earn" those sums, you just invested that £2 and let compounding do the work.

The longer you leave investments to compound, the greater the benefit. 

IAMIAM

you get a 10% annual return - Where does this actually happen though in cash terms....

Thrugelmir

IAMIAM said:

you get a 10% annual return - Where does this actually happen though in cash terms....

That applies to the reinvestment of income received. 

MaxiRobriguez

IAMIAM said:

you get a 10% annual return - Where does this actually happen though in cash terms....

Here's an example:

The S&P 500 (essentially the US Stock market) is up 28% in 2021.

If you whacked £1,000 in an S&P500 tracker on 1st Jan 2021 then that investment would be worth £1,280 today.

You have two options with this investment you own. You can:
1) Sell it, taking your £280 profit and doing something with the money.
2) Leave it, and hope you get further gains in 2022.

Let's say you chose option two, and the S&P500 goes up 3% in 2022 - because 28% gains this year was quite large so we expect next year to not be as good. You apply that 3% gain to the £1,280 figure, not £1,000, so your investment at the end of 2022 is now worth £1,318.

You can now sell your investment for £1,318, or you can leave it to see what happens in 2023.... 

Let's say you leave it, 2023 the S&P500 remarkably goes up lots again - this time 23%. Your investment is now worth £1,620.

That's a >£300 increase in a year, a bigger £ increase than the first year when you got 28% return. This happens because even though it's a small % increase, you're applying the increase to a bigger initial figure. 

Compounding magic happens after many years of being invested, when even small increases generate large returns. Simply - even a 1% gain on £1m investment gives a better £ return than a 10% return on a £50k investment. It just takes time to get up to those bigger figures. The key to achieving it is to invest as much as you can, as early as you can.

grumiofoundation

IAMIAM said:

you get a 10% annual return - Where does this actually happen though in cash terms....

For compound interest to occur the interest cannot be withdrawn. Investment wise one solution is an accumulating fund.

In the example above if you withdrew the 20p interest after year 1, the next you you would get 20p again because you aren’t getting interest on the interest from year 1. 

This is often called simple interest where compounding doesn’t occur. 

Not sure though if your question is more basic - if you invest £1000 and get a 10% return after fees you now have £1100. 

Edit: for completeness see the post below by eakbanker re returns…

eskbanker

Just a note of caution - although the above dialogue focuses on 'annual return' to make a point about compounding, it's important to recognise that, while some investments may have long-term average returns in high single-digit territory, and even double-digit ones sometimes, it should of course be expected that there will be negative years too, so, rather than a sequence of +8% returns, it's more likely that they'd be, say, +20%, +5%, -30%, +25%, -12%, +18%, etc.

Perhaps this is stating the obvious, but, after a lengthy bull run, many investment threads on here underplay volatility and its psychological effect on inexperienced investors....

MaxiRobriguez

eskbanker said:

Just a note of caution - although the above dialogue focuses on 'annual return' to make a point about compounding, it's important to recognise that, while some investments may have long-term average returns in high single-digit territory, and even double-digit ones sometimes, it should of course be expected that there will be negative years too, so, rather than a sequence of +8% returns, it's more likely that they'd be, say, +20%, +5%, -30%, +25%, -12%, +18%, etc.

Perhaps this is stating the obvious, but, after a lengthy bull run, many investment threads on here underplay volatility and its psychological effect on inexperienced investors....

Indeed, I was trying to keep it simple.

One also has to factor in that inflation compounds too...

Prism

Compounding when talking about investing isn't just referring to the reinvestment of cash or dividends but also the capital or share price growth of the company. The main source of compounding takes place within the company itself assuming it has room to reinvest within the company to grow. You see this detail through the company reports. The share price over the long term tends to reflect this. Its a form of compounding but not as obvious and visible as getting dividends that you can see as cash and reinvest yourself.

Aminatidi

Have a play with this.

https://www.thecalculatorsite.com/finance/calculators/compoundinterestcalculator.php

For me it was an eye opener 

IAMIAM

Thanks for this. Just so I can have a browse, any recommendations on what current 500 trackers that are out there?