Have you ever heard of the Butterfly Effect? It’s the idea that a butterfly flapping its wings in Iowa could lead to a hurricane off the coast of Thailand. Little causes can have big effects, if given enough time.
This idea is nowhere seen more clearly than in the world of investing and, in particular, compounding interest.
What is Compounding Interest?
Let’s say that you invest £100 in a savings account that has a 5% return. At the end of the year, you’ll have £105 in that account. At the end of the next year, you’ll earn 5% on both the original £100 as well as the additional £5. It doesn’t take a genius to realise that, by continuing to invest and allowing your earnings to be reinvested, you can steadily compound £100 into £1,000 – or more.
If you’ve ever tried to build a snowman, you know the basic principle. You start out with a small snowball, but as you roll it around in the snow it grows, adding layer after layer. Compounding interest is this exponential power of growth. And you can use it to become a millionaire by the time you retire. But if you’re going to take full advantage of it, you ought to keep these things in mind…
How Can I Use Compounding Interest To My Advantage?
- Start Early
The earlier you start investing, the more opportunity your investment has to compound. In fact, a person who invests £2,000 a year from age 19 until age 26 will end up with around £250,000 more than someone who invests £2,000 a year from age 27 until age 65 at an average 7% investment return. The earlier that you get that snowball rolling, the more it will accumulate. But don’t be discouraged if you’re already in your thirties, forties, or even fifties, instead of thinking about what might have been, focus on what could be now. So get started as early as possible, even if that’s today. - Search for a Good Rate of Return
Just as something small like a butterfly’s wings flapping could make a monumental difference down the line, a small difference in your investment’s rate of return can make a huge impact on how much money you end up with forty or fifty years down the road. Before you invest, search for the best return whether it be a dividend from a solid stock investment, a bond or a simple savings account. Return on investments typically average between 4 and 10 percent. - Learn Patience
When we talk about compounding interest, we’re not talking about a get-rich-quick scheme. You’re not going to turn £500 into £1,000,000 over the course of a year or even ten years. However, if you’ll faithfully invest £100 or £200 or £500 per month where it will give a fair rate of return, and if you’ll learn to patiently wait, then you will be rewarded. Consider this: if you saved £500 per month at a rate of 8%, you’d become a millionaire in 34 years. Remember the old saying, ‘good things come to those who wait.’ - Enjoy Life
Building up a savings is important. After all, you never know what may lie around the corner. But it’s important to temper all of this advice with a seemingly contradictory piece of advice: enjoy life. Don’t wait until you’re 60 years old to start living. Invest what you can but don’t forget to appreciate and enjoy what you’ve already been given.