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The Magic of Compound Growth Explained

In this lesson we reveal the best-kept secret about building your wealth – how regularly investing a modest amount in the stock market each month delivers prosperity through the magic of compound growth.

Growth shares

What is compound growth?

Compound growth is the process whereby the money that you’ve already earned is put to work to earn even more money. Think of it like earning interest on interest.

With compounding your returns will multiply very quickly. It’s akin to pushing a snowball down a hill – it won’t be too long before the ball mushrooms in size.

And the sooner you start putting your hard-earned cash to work, the longer you will have for the compounding effect to work its magic.

Compound growth is an investor’s best friend and everyone can get in on the action by putting aside a relatively modest sum each month to invest in the stock market.

This is how compound growth works

Netflix

Growth stocks such as Netflix have richly rewarded investors. The effect of compounding magnifies those returns

Breaking it down, the compounding effect is where you add the return from the first period of investment to the initial investment amount and then carry the new balance over to the next year. You then apply the growth rate to the new balance that includes the interest previously earned.

In this way your money will grow much faster than if you simply just added up the returns at the end of each year.

For example, if you invested £1,000 at a growth rate of 10%, at the end of the year 1 you will have earned £100 interest. The balance at the end of the year is now £1,100 (see table below).

Now in the second year instead of applying the 10% growth rate to your initial investment amount in Year 1, you apply it to the end balance of the first year (1,000 + 100 = 1100).  The amount of interest earned in the second year rises to £110. That is added to the initial balance in Year 2 (1,100 + 110 = 1,210), and so on.

If you had just applied the growth rate to the original amount each year you would have earned 100 x 5 = £500.

With compounding, you grow your money by £610.

Year Growth rate calculation Growth earned End balance
Year 1 £1,000 x 10% £100 £1,100
Year 2 £1,100 x 10% £110 £1,210
Year 3 £1,210 x 10% £121 £1,331
Year 4 £1,331 x 10% £133.10 £1,464.10
Year 5 £1,464 x 10% £146.41 £1,610.51

 

How the stock market beats cash

sterling cash

Now let’s look at a real-world example to compare the difference between putting your money to work on the stock market and putting it into a cash savings account.

The return (growth rate) on the UK’s FTSE 100 stock market index averages 7% over the past five years, with dividends (earnings from your shares) reinvested.

Let’s say you invest £100 a month for 10 years in the FTSE 100. With the compounding effect, by the end of the 10th year you will have £17,610, of which £5,510 will be from the compounding of your returns.

But if you had put your money into cash savings, where the best rates are around 1.3%, your money would have earned £5,000 less!

You would have just £12,935 compared to £17,610 with a stock market investment.

How stocks beat gold

Gold Trading

Historically over the long-term stock market returns outperform all other major asset classes, such as bonds, cash and gold.

Take gold, for instance, which unlike stocks and bonds does not generate an income. Investors buy it for safety and with the expectation that the price will rise to generate a return.

Also, in addition to not having any yield (income generation), there is the custody costs associated with gold, which is another drag on returns.

So even with gold, stocks are the winners.

£1,000 invested in gold 10 years ago, would be worth roughly £1,500 today, compared to £2,009 if the same amount had been invested in the FTSE 100.

Work out how much your investment could be earning