Albert Einstein once said: “Compound interest is the eighth wonder of the world. He who understands it earns it… he who doesn’t pays it.”
Richard Thaler, another Nobel Prize winner, but almost 100 years later, said: “It is at least as important as trigonometry and therefore should be taught in schools.”
So perhaps we ordinary folk should take note. What is compound interest and why is it so important?
Compound interest, put simply, is ‘interest on interest’. It assumes that any interest earned on an initial investment is reinvested. Taking it right back to basics, farmland can produce crops; these crops can then be sold; and the proceeds used to buy more farmland. The more fields, the more crops to be sold, and so on.
It can have negative consequences, however. Any interest applied to a debt is also added to the original debt. This means that the debt grows and the interest payment also increases.
Most readers are probably familiar with the concept but, in my experience, few people recognise compound interest’s true power. An example that focuses on debt is sometimes the most powerful. A quick search of the internet reveals that a you could pay interest of 1,575% on a loan. If you took out a loan of £250, that doubles after just three months as you will have to pay £256* in interest. Just about doable, I hear you say. But if you leave it for 12 months, you will have to pay back £4,187 – of which £3,937* is interest payments. Remember when Wonga first launched with rates of 5,853%? After a year, your debt [of £250] would have grown to £14,632*. Compound interest is scary. But the shocking numbers do help illustrate the first lesson we can learn: pay off your debts as soon as you can.
The good news is that you can benefit from compound interest too. The title of this article is “How the UK stock market doubled in value… without even moving”. This is actually a reference to compound interest.
Back on 30 December 1999, the FTSE 100 – an index of the UK’s largest 100 companies – closed at a level of 6,930. After the technology bubble burst in the early 2000s sending stock markets tumbling, then the global financial crisis took hold a decade later and, more recently, trade wars and geopolitical concerns took their toll, the FTSE 100 ended 2018 at 6,728. At the time of writing (12 February 2019), it is at 7,129.
If you had invested £250 in the stock market at the turn of the millennium, it would be worth £257** today. In other word’s it has barely moved.
However, if you had reinvested the dividends paid by FTSE 100 companies in that time, your pot of money would have doubled to £502**.
UK Equity Income funds look specifically for companies that pay dividends. If you had invested in the best performing UK Equity Income fund over the same time period – Schroder Income – and reinvested those dividends, you would have £1,171**.
Shorter term, the reinvestment of dividends can be just as useful. As the managers of Artemis Income pointed out recently: “That 2018 is over is probably the best that can be said about it. After having spent much of the year watching Wall Street’s [the US stock market] exuberance from the sidelines, UK investors were engulfed in the aftermath of its collapse, as share prices here followed the US market lower.”
The UK stock market fell 12.48%*** over 2018, but if investors had reinvested their dividends, the fall was a slightly more palatable 8.73%***.
Having had so much uncertainty over Brexit, the UK stock market is very much unloved by overseas investors. However, it is currently yielding just shy of 5%. So even if the FTSE 100 price index return is negligible in the coming year, there is still a decent amount of income that can be earned or reinvested.
Two other UK Equity Income funds that have a great track record of increasing their dividends are Rathbone Income and City of London Investment Trust. Carl Stick has run Rathbone Income since 2000, and its dividend has increased in all but one of the intervening years. Benefiting from the revenue reserve pot investment trusts can use, City of London – run by Job Curtis since 1991 – has increased its dividends every year under his tenure.
The lessons from compound interest are clear. Pay off your debts, start investing early with whatever you have, and reinvest your interest to make the most of your savings over the long haul.
* Source: BBC payday loan calculator: Bbc.co.uk/consumer/24746198
** Source: FE Analytics, price and total returns in Sterling, 31 December 1999 to 12 February 2019
*** Source: FE Analytics, price and total returns in Sterling, 1 January 2018 to 31 December 2018
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Darius’s views are his own and do not constitute financial advice.
DARIUS McDERMOTT is managing director at Chelsea Financial Services and FundCalibre