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Compounding can be a powerful way to grow your wealth over time. It might sound complicated, but it’s actually quite straightforward. All it takes is time, patience and consistency. Let’s take a closer look at what it is, how it works and why it can be so beneficial.
What is compounding?
In simple terms, compound growth is growth on top of growth. The main aim of investing is to grow the value of your money, with any profit or gain you make on what you invest known as your investment return.
You might be able to take this return as income in some circumstances. But reinvesting it offers the potential for further growth on both the original amount you invested – and that profit.
If your investments continue to make a profit and you keep reinvesting those returns, this repeats year after year. This is known as compounding returns.
Over the long term, compounding can significantly increase the value of your investments. And to benefit from the potential for continuous growth compounding offers, you need to do very little except keep reinvesting your returns.
It’s important to remember that the value of your investments can go down as well as up, so you may get back less than you paid in.
An example of compound growth
Say you invested £5,000 in a fund that makes an annual 5% return, which you reinvest. The table below shows the potential benefits compounding could have on your original investment compared with withdrawing the 5% each year.1
| End of year | With compounding | Without compounding (5% return withdrawn each year) | |
| Original investment | Total amount withdrawn | ||
| 1 | £5,250 | £5,000 | £250 |
| 2 | £5,512.50 | £5,000 | £500 |
| 3 | £5,788.13 | £5,000 | £750 |
| 4 | £6,077.53 | £5,000 | £1,000 |
| 5 | £6,381.41 | £5,000 | £1,250 |
| 10 | £8,144.47 | £5,000 | £2,500 |
In this example, compounding means that at the end of 10 years, you’d have £3,144.47 more than you originally invested. If you’d withdrawn your 5% return each year, you’d have gained £2,500 over the same 10-year period – £644 less than if you’d reinvested your returns.1
1 For illustrative purposes only. Assumes no change to returns from 5%, that you keep your original £5,000 invested and no investment charges apply.
Things to look out for
Of course, our example makes several assumptions, the biggest being that your investment will make a 5% return every year. There’s no such guarantee this will happen with investments – you’re very likely to get different returns every year, and the value of your investments can go down as well as up.
It doesn’t account for:
- Fluctuations in markets
- Difficult economic conditions
- Companies cutting or cancelling dividends, which could affect returns and the amount you can reinvest.
However, although it’s just an example, it shows how leaving your investments to grow through compounding can be an effective way to increase your investment returns. The potential for compound growth over time is one reason why it generally makes sense to invest for medium to long-term periods.
The bottom line
One area where compounding can have big benefits is investing for retirement, particularly when you start investing as early as possible.
By starting to save into your pension early, you’ll have years until retirement for your pension savings to potentially grow and benefit from compound growth. This can really add up across the decades. If you started saving later, you’d need a much more significant regular investment to end up with a pension pot of a similar value.
Now you know about the benefits of compound growth, why not try our Pension Calculator today? It can show you how compounding could help you reach your retirement goals.