The power of compound interest is often held up as something which is almost ‘miraculous’.

Take the case of two people who wish to save for retirement at 70.

One starts saving regularly at the age of 21 and saves for nine years and stops at age 30 but leaves their money invested.

The other starts saving at age 30 and continues to put money aside for the next 40 years.

If both retire at 70, who would be better off in retirement?

The surprise answer is that it is quite likely to be the first person and the reason is the power of compound interest.

The principle behind compounding is that each year you earn interest not only on the original amount invested but on the interest from previous years as well.

There is no miracle involved; it is simply that the potentially exponential growth encouraged by compounding over time can be quite remarkable.

If you invested €10,000, assuming a fixed growth rate of 5% pa, it would worth after:

  • 10 years               €16,470
  • 20 years               €27,126
  • 30 years               €44,677
  • 40 years               €73,584

These figures are for illustrative purpose only. The actual value of investments and the income from them can go down as well as rise.

Some investors are nervous about putting their money into ‘risk assets’ such as shares but historical data shows that over the long term, so called ‘riskier asset classes consistently deliver better average annual returns than cash savings or bonds.

The effect of compounding on these better returns means that, assuming the price of the asset grows in a reasonably consistent way, the difference becomes greatly more important the longer your stay invested.

For shares, apart from the value of the stock itself; the effect of compounding can be boosted by reinvesting any dividends paid out to you as a shareholder.

The conclusion is simple: Invest early, add to your investment pot regularly and give serious consideration to investing in riskier assets to make compound interest work hard for you.