Compound Interest

CCG___87

Hi, 

I'm having a bit of trouble understanding how compound interest works, if anyone can help please! I've read other articles and watched loads of youtube videos but still slightly confused.

I have a stocks and shares ISA with HL and invest £1000 monthly into Fidelity Index World (Class P - Accumulation). 

Using a compound interest calculator, if I invest 1k a month for 20 years, with a yearly interest rate of 5%, I would have £411,033.67 and of that would be £171,033.67. 

Is it really that simple? If the fund returns an average 5% return over 20 years I'll earn £171,033.67 interest?

I only ask because the HL stocks and shares account only pays interest on cash balance, so I want to make sure I'm benefiting from compounding with this account. Or would I need another type of account?

Any help would be appreciated

Thanks! 

mebu60

You do not get interest on stocks and shares investments so compounding is irrelevant in that respect.

Compounding applies to cash savings where interest is subsequently applied to previously accumulated interest. 

gravel_2

mebu60 said:

You do not get interest on stocks and shares investments so compounding is irrelevant in that respect.

Compounding applies to cash savings where interest is subsequently applied to previously accumulated interest. 

Compounding also applies to investments.

Albermarle

Fidelity Index World is a global stock market tracker.
So it goes up and down in line with the markets + pays a small dividend.
It does not pay interest.

CCG___87

Thanks for the replies.

So let's say I keep investing 1k a month into this fund, and after 20 years, the average annual return has been 5%, how would I work out what that would be worth after 20 years? Is that calculation above with the compound interest calculator not applicable in this type of investment?

Would I be better investing into another fund which pays interest, to benefit from compounding? Fairly new to all of this so just trying to get my head around it! 

Veteransaver

CCG___87 said:

Thanks for the replies.

So let's say I keep investing 1k a month into this fund, and after 20 years, the average annual return has been 5%, how would I work out what that would be worth after 20 years? Is that calculation above with the compound interest calculator not applicable in this type of investment?

Would I be better investing into another fund which pays interest, to benefit from compounding? Fairly new to all of this so just trying to get my head around it! 

You'd need to do an NPV or cashflow analysis on a spreadsheet

EthicsGradient

CCG___87 said:

Hi, 

I'm having a bit of trouble understanding how compound interest works, if anyone can help please! I've read other articles and watched loads of youtube videos but still slightly confused.

I have a stocks and shares ISA with HL and invest £1000 monthly into Fidelity Index World (Class P - Accumulation). 

Using a compound interest calculator, if I invest 1k a month for 20 years, with a yearly interest rate of 5%, I would have £411,033.67 and of that would be £171,033.67. 

Is it really that simple? If the fund returns an average 5% return over 20 years I'll earn £171,033.67 interest?

I only ask because the HL stocks and shares account only pays interest on cash balance, so I want to make sure I'm benefiting from compounding with this account. Or would I need another type of account?

Any help would be appreciated

Thanks! 

Since investments don't pay interest (and their returns vary widely and can be losses too), then, no, it's not that simple. 

gravel_2 says "compounding also applies to investments" - yes, in a sense. Since you hold an accumulation fund, the dividends that the constituent companies pay get re-invested back into the fund, and so hopefully they will grow over time too. It will all be tied up together in the fund unit price, so you won't be able to see what it was that came from re-investing. If you have an Income version, they'd pay those dividends into the cash balance of your ISA instead. It's having the Accumulation version that gets you the investing equivalent of compounding, not your HL account.

Since you're also investing regularly, there's no easy way of showing what your total returns might have looked like over a previous period. But you can do that for a lump sum. Here's a chart for the past performance of Fidelty Index World Class P - both Accumulation and Income

Chart Tool | Trustnet

At first, you should see just one line, since the chart default to showing income re-invested, which makes the Inc version behave just like the Acc version. But click on "Chart Basis" and select "Without Income Reinvested" (and you can also choose "£ return" rather than "% return" there if you want, and you'll see that over 5 years from May 2019, £1000 in the Acc version became about £1839, and the Inc version £1689. Over 10 years (ie from May 2014) it became £3226 and £2742 respectively. Much of that difference would have been cash dividends paid back to you - but some would be extra growth by having the dividends re-invested instead.

CCG___87

Are the calculations from this explanation in the video incorrect then? He uses the S&P500 with an average return of 10% for his calculations. I did the same when trying to calculate mine above, except mine is a global tracker, so just assumed the calculations would be the same? I thought it might be too simple to be true 

gravel_2

EthicsGradient said:

CCG___87 said:

Hi, 

I'm having a bit of trouble understanding how compound interest works, if anyone can help please! I've read other articles and watched loads of youtube videos but still slightly confused.

I have a stocks and shares ISA with HL and invest £1000 monthly into Fidelity Index World (Class P - Accumulation). 

Using a compound interest calculator, if I invest 1k a month for 20 years, with a yearly interest rate of 5%, I would have £411,033.67 and of that would be £171,033.67. 

Is it really that simple? If the fund returns an average 5% return over 20 years I'll earn £171,033.67 interest?

I only ask because the HL stocks and shares account only pays interest on cash balance, so I want to make sure I'm benefiting from compounding with this account. Or would I need another type of account?

Any help would be appreciated

Thanks! 

Since investments don't pay interest (and their returns vary widely and can be losses too), then, no, it's not that simple. 

gravel_2 says "compounding also applies to investments" - yes, in a sense. Since you hold an accumulation fund, the dividends that the constituent companies pay get re-invested back into the fund, and so hopefully they will grow over time too. It will all be tied up together in the fund unit price, so you won't be able to see what it was that came from re-investing. If you have an Income version, they'd pay those dividends into the cash balance of your ISA instead. It's having the Accumulation version that gets you the investing equivalent of compounding, not your HL account.

Since you're also investing regularly, there's no easy way of showing what your total returns might have looked like over a previous period. But you can do that for a lump sum. Here's a chart for the past performance of Fidelty Index World Class P - both Accumulation and Income

Chart Tool | Trustnet

At first, you should see just one line, since the chart default to showing income re-invested, which makes the Inc version behave just like the Acc version. But click on "Chart Basis" and select "Without Income Reinvested" (and you can also choose "£ return" rather than "% return" there if you want, and you'll see that over 5 years from May 2019, £1000 in the Acc version became about £1839, and the Inc version £1689. Over 10 years (ie from May 2014) it became £3226 and £2742 respectively.

Is this oversimplifying (or potentially being pedantic?). I was not referring only to dividends being reinvested. The capital growth of any investment (whether unrealised, or realised and reinvested) also serves to compound. Perhaps not as straight forward as principle + bank interest but still it compounds over the years, both gains and losses.

CCG___87

EthicsGradient said:

Chart Tool | Trustnet

At first, you should see just one line, since the chart default to showing income re-invested, which makes the Inc version behave just like the Acc version. But click on "Chart Basis" and select "Without Income Reinvested" (and you can also choose "£ return" rather than "% return" there if you want, and you'll see that over 5 years from May 2019, £1000 in the Acc version became about £1839, and the Inc version £1689. Over 10 years (ie from May 2014) it became £3226 and £2742 respectively. Much of that difference would have been cash dividends paid back to you - but some would be extra growth by having the dividends re-invested instead.

This is really useful thanks!

LeafGreen

The way compounding works is it's effectively interest on interest.  So if you deposit £1000 in a standard savings account at 5% after 1 year you will have £1050, so £50 interest.  In year 2 if it's still 5% with no further deposits you'll be getting 5% on £1050 which is £52.50.  Year 3 £55.12 interest and so on - each year the interest is a bit more.

The thing with investments is that the returns will fluctuate massively more than a regular savings account, so they are not really comparable.  One year might be +8%. another +3%. another -6% (i.e it might go down).  And there will be ups and downs on a day-to-day basis.  But the principle kind of still applies - if the value of your investments did go up 5% in year 1, then the value of those investments would then be higher ready to possibly go up another 5% in year 2.

With investments vs savings you are comparing certainty of a fixed return of a savings account with potentially higher but not guaranteed returns of investments.  Generally investments do outperform savings accounts over the longer term, but it's not guaranteed and it can be a bit of a roller coaster.  You should also make sensible choices regarding what exactly your money is invested in.