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Long-term ISA investing – the compound effect

Attempting to time the markets to perfection is without doubt one of the biggest and most common mistakes that any investor can make. If hedge funds’ sophisticated AI-driven computer algorithms are unable to do it, then what chance do the rest of us have?

Not only is it virtually impossible to do, but it is also pretty futile. Waiting for a stock to drop another two percent might make you feel like you have bought a bargain, but over a long investment horizon, it isn’t going to make much impact at all. Even worse, investors waiting for the ‘right price’ may miss out on top-quality stocks altogether.

Instead of focusing on timing the markets, investors should concentrate on time in the markets. Long investment holding periods benefit from the power of compounding – basically the principle of interest accumulating on interest. The longer the holding period, the bigger the compound effect.

The table below shows the effect of compounding over time, assuming inflation-adjusted share returns of 5.5% (the average real UK share return from 1969-2018 – including the reinvestment of dividends).

Holding period (years)

£10,000 initial investment

£50,000 initial investment

10

£17,081

£85,407

20

£29,177

£145,887

30

£49,839

£249,197

40

£85,133

£425,665

50

£145,419

£727,098

60

£248,397

£1,241,988

The table shows that the longer the holding period, the larger the incremental monetary increase in the investment value. For example, in the first 30 years, an initial £10,000 investment increases in value by £39,839. But in the 30-60 year holding period, the value of the investment increases by a huge £198,558.

With an initial investment of £50,000, holding an investment for an additional 10 years (from 40 years to 50 years) results in an extra gain of £301,433.

The table also shows – intuitively – that the more that is invested initially, or early on, the better, with investments made later having less time to benefit from compounding. This has huge implications for young people that are contributing to pensions.

From this point of view, it makes sense to contribute as much as possible, as early as possible. It’s an unfortunate irony that earnings are often at their lowest right at the point when it’s most important to be making large contributions, with the reverse also holding true.

The compound effect also demonstrates the value of opening Junior ISAs for young children. Maxing out the savings limit of £4,368 at birth would be worth £141,805 after 65 years (investing at the rate above) – which I’m sure would come in very handy to most retirees!

I think it’s vital that young people understand the benefits of investing at an early age. I would recommend diverting some money towards a stocks and shares ISA, if possible, and investing a regular amount each month. A Lifetime ISA could work just as well, maybe even better. It could make the difference between a comfortable retirement and a difficult one.

For those that are nearer to retirement, and after a bigger pot, it’s important to note that to better the returns outlined above, then it’s likely that investments will have to be less diversified, and thus riskier…

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