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What is compound interest? [video]

And why it’s the principle on which most great fortunes are built...

Andrew Craig, a financial author and educator, shares how compounding interest is so important for your investments...

RP: One of the most important concepts for investors to grasp is compounding.

It’s the principle on which most great fortunes are built, and it’s far more powerful than you might imagine.

Here is the financial author and educator Andrew Craig.

AC: Einstein described compound interest as the eighth wonder of the world. One of those things where you can find that quote a lot online, but then you can also find people saying that he never said that. But, whether he said it or not, I’ll take it because it is as important as that, in my view. And it’s one of the great failures of our education system that too few people understand the power of compound interest.

RP: So, that’s how important compound interest is. But what exactly is it?

AC: Compound interest is where you take £1000, let’s say. You make ten per cent in over, let’s say, one year. So at the end of the year, you have £1100. If you do that again: the following year, you make £110 in return so you’ve got £1210. And crucially, that £10 is the return on your return. That is the beginning of compounding. Compounding to me just means the return on your return, and what that means to any mathematician is a geometric progression. It means that the curve gets steeper over time, and the return on your return becomes more.

RP: To illustrate the power of compounding in the talks that he gives, Andrew uses a simple example; and it’s this.

AC: If on the day a child is born, a wealthy relative — or parent or whatever — puts £5000 into some sort of investment, and that investment (we can potentially get into how this might be possible) but that investment, just for the sake of mathematical simplicity and illustrating a point, returns ten per cent per annum:

On the first day that child can legally retire — on their 55th birthday — they’ll have £945,000 in their account. And so I always say, how can we possibly have a pensions crisis? How can people struggle financially if a one-off investment of £5000 can imply that somebody’s got nearly £1million by the time they retire?

RP: So, harness the power of compounding. If you haven’t started investing yet, don’t put it off any longer.

And if you want to give a child a financial head-start, just invest some money for them. Simply leaving it invested will produce extraordinary long-term results.

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