The Miracle Of Compounding!

Start saving early and you can benefit from the miracle of compounding.

Sorting out your finances is not the most fun job in the world -- I'm sure you can think of better ways to spend an afternoon. But a couple of hours of putting a savings plan in place are time well spent - especially if you know the secret of the miracle of compounding!

And don't think you need to be loaded to make use of this secret -- all you need to know is that time is the most important factor if you want to make money.

Let's look at an example:

Sarah is 20. She earns £20,000 a year and sensibly decides that she's going to start investing. She can afford to put £100 each month into an index tracker ISA. She sets up the direct debit and forgets about it.

Ten years later, Sarah is 30. She's just got married and has given up work for a few years to have children, so she decides to cancel her direct debit.

Sarah's husband David is also 30. Unlike Sarah, he spent his twenties spending money on beer and iPods --but now he has responsibilities and decides to start investing. David picks the same index tracker to invest into as Sarah and he sets up his direct debit for £100 each month, continuing to pay into it until they both decide to retire at 60 (hey, it's only an example!).

So, how much do Sarah and David now have in their ISAs? Take a look at the table below:

*Calculations assume an average annual return of 9% after charges.

But hang on a minute - Sarah only paid into her ISA for ten years (total payments = £12,000), but ends up with £82,000 more than David, who paid into his for thirty years (total payments = £36,000)?

This can't be right. Can it?

Well, yes it can. And the reason why? The miracle of compounding!

Sarah's investments have been growing steadily and importantly, she's been receiving interest on that interest. So even though she only invested for ten years, because she has left it to grow for forty years she's benefited from these fantastic compound returns. And even though inflation will erode these returns, she should still end up with a healthy sum.

David's investments have grown too, but as he started ten years later, he's playing catch-up -- and even with an extra twenty years of payments he's still trailing far behind Sarah.

The secret of the miracle of compounding is therefore to start as early as possible and get the best returns you can - which usually means paying the lowest charges possible. Hence an index tracker (several have total charges of under 0.5% a year) is the place to start.

So you know what to do, don't you? Start investing now. Don't worry if it's only a few pounds, with compounding it'll soon grow. If Sarah had only squirreled away £50 a month, she'd still have ended up with nearly £128,000. Not bad for a £6,000 investment. See what you can expect by using this calculator.

You could invest up to £7000 in a shares ISA in this tax year. That's unless you've already opened a cash ISA in which case you could invest up to £4000 in a shares ISA.

So what are you waiting for? Start investing and you can take advantage of the miracle of compounding too!

More: The Miracle Of Compound Returns

An earlier version of this article was published in March 2005.