What is compound interest?

What is compound interest? 

Compound interest is perhaps the single most powerful tool investors can use to grow their wealth, yet it remains one of the most misunderstood. It's the principle on which most great fortunes are built, and its effects over time are far greater than most people imagine. So what exactly is compound interest, and how can you put it to work?

In this video, financial author and educator Andrew Craig explains what compounding is and why it matters so much. Compound interest is often called the eighth wonder of the world, a description frequently attributed to Einstein, and whether or not he ever said it, Craig argues it's every bit that important. He calls it one of the great failures of our education system that so few people truly understand its power.

You'll learn the mechanics in simple terms. Take £1,000 and earn 10% in a year, and you have £1,100. Earn 10% again the following year and you make £110, giving you £1,210. That extra £10 is the return on your return, and that is the essence of compounding. Mathematically, it's a geometric progression, which means the growth curve gets steeper over time as your returns start earning returns of their own.

To show just how dramatic this can be, Andrew Craig shares a striking example. If, on the day a child is born, a parent or relative invests £5,000 at an assumed 10% annual return, by the child's 55th birthday (the earliest they can legally retire) that single investment would have grown to around £945,000. It prompts a powerful question: how can we have a pensions crisis when one modest, one-off investment can grow to nearly £1 million by retirement?

The takeaway: harness the power of compounding. If you haven't started investing yet, don't put it off any longer, because time is the ingredient that makes compounding work. And if you want to give a child a real financial head-start, invest something for them early and simply leave it to grow. The long-term results can be extraordinary.

Chapters / Key points

• Why compounding is one of the most important concepts for investors
• The "eighth wonder of the world" and the Einstein quote
• Why so few people understand compound interest
• What compound interest actually is, explained simply
• Why it's the "return on your return"
• How compounding becomes a steepening geometric progression
• The £5,000 example: turning a birth gift into nearly £1 million
• Why starting early matters so much
• How to give a child a financial head-start

Transcript

Why compounding is so powerful

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 £1,000, let's say. You make ten per cent over, let's say, one year. So at the end of the year, you have £1,100. If you do that again, the following year you make £110 in return, so you've got £1,210. 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 £5,000 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 £5,000 can imply that somebody's got nearly £1 million 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.