Finance > Investing in the Stock Market
The Effect of Compounding
Compounding is the effect of reinvesting your returns, leading to the generation of additional earnings. In short, it is growth on top of growth. By reinvesting your returns, rather than taking the profit, you are adding to the size of the pot for which the next period of growth can occur. Over time, the growth will occur faster than if you were to withdraw your profits.
Example:
If you invest £2,000 per year for 10 years and it grows by 10% per year, your investment would be worth £35,062 at the end of the 10 years.
| Year | Yearly Investment | Invested Total | Growth | Compounded Total | Profit |
|---|---|---|---|---|---|
|
1 |
£2,000 |
£2,000 |
10% |
£2,200 |
£200 |
|
2 |
£2,000 |
£4,000 |
10% |
£4,620 |
£620 |
|
3 |
£2,000 |
£6,000 |
10% |
£7,282 |
£1,282 |
|
4 |
£2,000 |
£8,000 |
10% |
£10,210 |
£2,210 |
|
5 |
£2,000 |
£10,000 |
10% |
£13,431 |
£3,431 |
|
6 |
£2,000 |
£12,000 |
10% |
£16,974 |
£4,974 |
|
7 |
£2,000 |
£14,000 |
10% |
£20,872 |
£6,872 |
|
8 |
£2,000 |
£16,000 |
10% |
£25,159 |
£9,159 |
|
9 |
£2,000 |
£18,000 |
10% |
£29,875 |
£11,875 |
|
10 |
£2,000 |
£20,000 |
10% |
£35,062 |
£15,062 |
Now let’s say you leave your portfolio of £35,062 for a further 30 years to grow and only reinvest the profits you receive, you will see the effect of compounding work its magic.
| Year | Growth | Compounded Total |
|---|---|---|
|
15 |
£21,406 |
£56,468 |
|
20 |
£55,880 |
£90,942 |
|
25 |
£111,401 |
£146,463 |
|
30 |
£200,818 |
£235,880 |
|
35 |
£344,824 |
£379,886 |
|
40 |
£576,749 |
£611,811 |
After 30 more years, your portfolio of £35,062 has grown to £611,811!
This table not only outlines the power of compounding but also how much greater the compounding gets with time. For example, if you start this process at 20 years old, by the time you’re 60 years old, you would have a final sum of £611,811 from an initial investment of £20,000. However, if you started this process at 30 years old, by the time you’re 60 years old, you would have generated £235,880. As a result, starting 10 years later means you have missed out on £375,931 of compounded growth!
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