Compound Interest

EthicsGradient

gravel_2 said:

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.

Well, capital growth is a trickier concept - for a share, IT or ETF, it comes from the price the market will pay for a unit; this isn't based on just "it should be x% more than last year", but on all the ideas around what a company is worth (one part of which could be retained profits that are invested in future growth, but lots more too). And for a fund, it's the total of the traded commodities that it holds and are valued by markets in the same way.

Also, the decision to take income or let it accumulate in fund units is straightforward, and quite like having savings interest paid to you or compounding inside an account. Taking your capital growth out as cash too would involve selling some units regularly.

CCG___87

grahamgoo said:

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.

Thanks, I think this is what I'm trying to understand here. Say for example I have £10,000 in a fund. That fund grows by 10% in a year, and is now worth £11,000. Say I don't invest anything else, and it grows again the following year by another 10%, would that be worth £12,100 and so on? 

It's essentially what this guy is saying in the video below (Linked it to the exact time) - is what he's saying incorrect? I've seen a lot of videos like this which make it sound really simple, but turns out it isn't? Apologies if I'm sounding stupid here, just can't seem to get my head around it.

https://youtu.be/kkO2yd2hILA?si=q1xBvhkC21nXDONJ&t=139

coyrls

With a savings account, you know the interest and apply that to the capital to calculate growth.  With an investment, the % growth is only known in retrospect, so saying it's grown 10% to £11,000 and therefore if it grows another 10% it will be worth £12,100 is true but trivially true.  The fact that it's grown 10% in one year has no bearing on what its growth will be in the future.

mebu60

gravel_2 said:

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.

I was trying to keep things relatively simple and straightforward for the OP. Technically yes, investment income / gains can be reinvested and the growth or loss compound. 

Ivkoto

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! 

Yes if the average return over 20 years is 5% your maths is correct.

poseidon1

Seems to me without getting complicated would it not be simpler to state that the concept of compound interest on cash savings simply does not apply to investing!

The compound return on cash at a simple rate of interest is entirely predictable and largely risk free (ignoring inflation), whereas the 'investment' return on accumulating monies in a stockmarket linked fund is not. 

It is perfectly possible for ones' compound 10% annual 'return' over say 10 years to take an almighty hit in year 11 by a black Swan event ( such as the 2008 financial crash),  erasing a good percentage of those prior years returns. Yes, if you are able to hold your nerve and not bail out of the investment at that time, good likelihood of recouping losses even without investing new money.

However, you would have no such concerns with your compound interest returns on cash.

It is somewhat concerning that the OP, has been unable to grasp these basic concepts via his monthly HL investment account. The interest paid by HL is minor and incidental to the OP's main activity of investing in the World's stockmarket quoted businesses where he should have noted valuations fluctuate daily.

I find it also significant that having eventually grasped from some  forum members comments, that compound interest does not apply to 'investment' returns, the OP then asks should he invest in a fund where interest does compound ( presumably with the predictability of cash at bank ).  Although there  are of  course unit trust funds linked to pure cash returns, no one in their right mind would recommend these over straight forward retail bank deposits.

I think grahamgoo hit the right note with his post.  Really cannot compare apples with pears here, and the OP has more (basic) self education to do to  appreciate and understand what he is currently doing ( he is nowhere near the NPV, cashflow analysis spreadsheet level as yet!)

Ivkoto

The OP question was very simple, but some of you are trying to make it looks very complicated.
He asked, if the AVERAGE return over 20 years is 5%, what would be the final result. He didn't asked what would have happened if at year 21 the fund lost 50% or whatever.

CCG___87

 Ivkoto said:

The OP question was very simple, but some of you are trying to make it looks very complicated.
He asked, if the AVERAGE return over 20 years is 5%, what would be the final result. He didn't asked what would have happened if at year 21 the fund lost 50% or whatever.

Yep, that's pretty much all I wanted to know  This is going to be a long term, set and forget thing, and after watching those videos/reading articles, I wanted to double check the info and understand how investments like these grow. I know it will fluctuate and I could lose money, but since the average return on s&p500 for example has been about 9% over the last 30 years, it gives me a rough idea on what the investment could potentially turn out to be in the future. 

Thanks everyone 

eskbanker

Conscious that a simplistic view is sought, but generally worth considering other factors when being seduced by high long term growth percentages, namely inflation, fees and currency fluctuations.

Even if the headline growth rate of a fund was 9% annually, the real terms value is eroded by inflation - less of an issue if that's at 2-3% than if it's, say, 5-6%, but definitely worth bearing in mind when modelling returns, i.e. net post-inflation ones are more meaningful than gross.

Likewise with fees - HL is a significant player, but its 0.45% annual fee is potentially a significant drag on returns, when compared with low cost platforms such as IWeb.

Finally, exchange rates - not much you can do about them if investing elsewhere such as the USA, but again they can make a substantial difference to returns.

OldScientist

The tool at https://www.moneysavingexpert.com/savings/savings-calculator/ (choose the 'how much could I have if I save regularly?' option) might be useful for you.

Of course, it is really for cash savings, but you can input a variety of expected returns instead (e.g., the 5% you mention above). If you put in expected real returns (e.g., if you assume 5% returns and 3% inflation, then stick 2% in as the interest rate - it is worth noting that real returns over a 20 year period have been negative in the past), then the size of pot calculated will be in real terms in today's money. As others have said, in reality the value of a shares fund like the Fidelity one you mention won't change smoothly.