Saying that a single concept can help you retire rich might sound extreme, but bear with me.
Today I’m going to talk about the one thing all new investors must learn and all experienced investors must remember. The fact that we’ve just experienced the worst quarter for stock markets since 1987 makes it even more relevant.
The most important thing
Forget all the fancy money-making strategies you’ve heard. To really increase your wealth, it’s more important to understand the concept of ‘compound growth’.
We experience compounding in everyday life, usually without even recognising it.
Suppose you want to get fit and decide to dedicate 10 minutes a day to exercising. Initially, progress is slow. Over time, however, workouts become easier and your body can do more.
The reason for this is simple: every bout of exercise builds on those previously completed.
Compounding can work against us too. Allowing ourselves an extra portion of something calorific at dinner might not feel wrong at the time. The result of doing so many times over many evenings, however, eventually shows on our waistline.
The little things we regularly do add up.
So, it can make me rich?
Yes. Compounding is the not-so-secret sauce that can also make you wealthy.
Imagine investing £20 in the stock market every month (or £240 per year) for the next 30 years. Over this period, markets rise in value and you re-invest any dividends you receive.
Although the actual rate of return will vary from year to year, let’s say your portfolio returns 10% per annum. So, after one year, your money increases in value by 10%. In the second year, the money you had after the first year increases by 10% and so on.
After 30 years, you’d have nearly £40,000. It’s grown by so much because you’ve earned interest on interest every year. Your money has compounded.
Remember, this is the hypothetical result of investing just £20 per month. Put away £50 a month and you’ll have almost £99,000 based on my figures. £100 a month will give you over £197,000. It’s not magic, it’s simple maths.
The only caveat is that there’s no guarantee the stock market will return that 10% average per year. It could be lower or higher, depending on what you choose to invest in and how those investments perform.
Compounding can make you rich, but it still requires two things from you: commitment and patience.
Just as practicing the violin once every year won’t lead to any meaningful gains in terms of ability, saving ‘when you feel like it’ is unlikely to substantially increase your wealth.
This is why setting up a direct debit to take even a small amount of money from your bank account to your ISA every month without fail is crucial. By automating your savings, you take out the need to be motivated to save.
Second, learning to delay gratification is vital. Warren Buffett’s wealth has increased massively in later life because he recognised that results aren’t immediate. He continued to invest, through good times and bad.
Which brings me back to the start. Having the courage to invest through market wobbles is desirable since it allows you to buy more when prices are depressed. The more stock you accumulate at lower prices, the greater the eventual upside will be.
Forget the market crash. Remember the power of compound growth.
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Paul Summers has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.