Step 1: The Miracle Of Compound Returns

Here at The Motley Fool, we believe the person who is best equipped to look after your money is you.

After all, only you really have your best interests at heart. You aren’t going to sell yourself a product you don’t need (did someone say PPI?) just because you’ll earn a big, fat commission payment or you need to make a monthly sales target.

Admittedly the financial world can seem scary at first. There’s jargon everywhere, and no end of scandals in the news. It’s also true that taking control of your finances does require some time and effort. But it’s certainly nowhere near as complicated as financial professionals and the media make out. In our view, most people are capable of not only doing it, but doing it well and even enjoying it!

If you have a little common sense, the ability to take a long-term view, and an inquisitive attitude (you should never be afraid to ask if you don’t understand something) then financial freedom should be well within your grasp.

In this 10-step guide we look at how to get your finances in tip-top shape. From getting out of debt, building up your savings, prospering from the stock market, and making sure your kids get off a good financial start – we’ve got it covered.

Compounding is the key

Let’s begin, though, with a look at what we often call the miracle of compound returns. It’s why the rich seemingly always get richer, while the poor never seem to catch a break.

In short, it is the process whereby money earned from an investment builds upon itself over longer periods of time. Crucially, earning a slightly higher rate of return can make a massive difference to the amount of money you end up with.

Consider this example of a savings account:

  • You earn some interest
  • Next year, you earn interest on that interest
  • The year after, you earn interest on the interest on the interest 
  • The year after that… and so on…

Compound returns are driven by two factors: rate of return and time.

Rate of return

The rate of return determine how quickly and how much your sum of money grows. The higher the rate, the more – and the faster – your money will grow. Let’s look at some numbers and see how this might work in practice…

How an investment of £100 per month can build up

 Age
started
Investment value at different rates
1% 3% 5% 7.5%
Age 20 0 0 0 0
Age 30 £12,626 £14,009 £15,598 £17,904
Age 40 £26,578 £32,912 £41,275 £55,719
Age 50 £41,998 £58,419 £83,573 £135,587
Age 60 £59,038 £92,837 £153,238 £304,272

Even small differences in the rate of return have a huge impact on the amount earned in later years. For example, the two percentage point difference between the 3% and the 5% figures result in a difference of over £60,000 after thirty years.

A good investment strategy can provide even higher annual returns, and if you can afford to put in a few or several hundred pounds a month, then you can probably see how serious sums can be generated this way. For simplicity here, we are ignoring the effect of inflation for the time being, but even taking this into account, hopefully it’s apparent just how important compounding can be.

Time

Another major factor in the growth of an investment is time – how long your investment has to appreciate. Time for some more numbers…

Comparison of a 5% return over different periods

 
  Age started
20 30 35 40
Value at
different
ages
30 £15,598 £0 £0 £0
35 £27,188 £6,962 £0 £0
40 £41,275 £15,598 £6,962 £0
50 £83,573 £41,275 £27,188 £15,598
60 £153,238 £83,573 £58,812 £41,275

What you should learn from this table: the sooner you start investing, the better. What you shouldn’t learn from this table: “I’m forty-five years old and I haven’t invested a penny! I won’t even bother – it’s too late!” No, no, NO. While obviously it is better to start early, late-blooming investors still get some time in the sun, we promise. All we’re saying is… well, get a move on!

How much should I put aside?

The short answer: as much as possible. We’ve used a figure of £100 for our examples, but don’t be put off if you can’t afford as much. Small sums soon build into bigger ones, and you can look at increasing the amount each year. The trick, as we’ve said, is to start early and invest steadily in order to get the miracle of compound interest working for you. There is more on compound returns on this page, including links to a couple of calculators where you can plug in some numbers for yourself.

Next we’ll look what you can do to make sure you do have spare money to invest.


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