The magic - and danger - of compounding

5 November 2018
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I’ve always been mesmerised by the magic of ‘compounding’, ever since I first came across it while studying economics and econometrics.

Forty years on, I haven’t quite fathomed out the econometrics bit of my degree

Compounding is a financial ‘trick’ that the late great Tommy Cooper would have approved of. If used in a savings or investment portfolio, it finally empowers – although, equally, it can prove destructive if employed against you as a borrower. “Just like that.”

I was probably first made aware of the importance of compounding in the early 1990s when I was contacted by a saver who felt they were not getting a fair deal from Alliance & Leicester (now subsumed into Spanish bank Santander).

The saver’s gripe was that the five-year, fixed-rate bond he had with the society failed to compound the interest promised over its term (interest being paid upon the bond’s maturity). Instead of the annual interest being compounded every year – with interest then earned on interest – each annual interest payment was effectively held in a suspense account and then paid over to the saver when the bond matured, together with the original amount invested. By doing this, Alliance & Leicester had eliminated the compounding of interest benefit for savers. There was no interest on interest.

I was outraged and said so in several editions of a national Sunday newspaper when I was compiling the money section. To Alliance & Leicester’s credit, it saw the error of its ways. One morning, I was called into my boss’s office – expecting the worst – only to be told the building society would be changing the bond’s terms. Not compounding interest was “unethical and not what the cuddly saver-friendly society was all about”, its chairman had called to say. Interest would, after all, be compounded. A mini victory.

Today, regular compounding of savers’ interest is a given although with Bank base rate at 0.75%, its impact is not as dramatic as it was in the early 1990s when base rate was fluctuating between 6% and 7%. But the power of compounding remains dramatic in the world of investing as a result of a boom in dividends paid by stock market-listed companies. Reinvesting dividends, instead of taking them as income, can really turbocharge an investor’s portfolio, especially if the underlying investments also perform well.

The positive impact of dividend reinvestment is easily demonstrated. I recently asked financial services company Hargreaves Lansdown to run some numbers on the performance of the FTSE 100 Index – a barometer of the stock market fortunes of the biggest 100 listed companies in the UK – since the horrible financial crisis of 2008.

If you had invested £10,000 in HSBC FTSE 100 Index fund in early November 2008 – a fund tracking the market’s performance – it would have been worth £13,703 a decade later. On top would have been a dividend stream over the decade worth £3,928, making a total return of £17,631. But if the dividends had instead been automatically invested, the £10,000 invested would have grown to £19,269. In other words, ‘compounding’ would have generated a performance boost worth £1,638.

With savings rates so low, many people are using shares, investment funds and trusts as a source of regular income. That is fine and they should continue to do so if the income is a necessity. But there are many investors who are putting money away inside a tax-friendly investment Isa or self-invested personal pension (Sipp) who are not reinvesting dividends. As a result, they are losing out on the magic of compounding.

So if you hold income-oriented unit trusts or open-ended investment companies (OEICS) in your portfolio, ensure they are the so-called ‘accumulation’ unit class. These automatically reinvest dividends back within the fund. Alternatively, if you want hands-on control, you can pick the alternative ‘income’ unit class, accumulate the cash from the dividends as they are paid and use them to buy whatever investments you like.

It’s a financial ‘trick’ Tommy Cooper would have liked

For income-friendly shares or investment trusts, most online investment fund platforms will now provide an automatic reinvestment service, enabling you to use any dividends to buy more shares.

Magic? Yes. Easy, yes. Financially enhancing? Absolutely.

One final point. While compounding weaves its magic on the saving and investing fronts, it can work against you as a borrower. For example, take out an equity release interest-only loan and your loan interest payments will be rolled up, adding to the loan’s size every time interest is compounded.

Without due care and attention, it can soon snowball out of control. “Just like that.” You have been warned.

The magic – and danger – of compounding.

Jeff Prestridge is the personal finance editor of The Mail on Sunday. He won the Contribution to Personal Finance Education category at the Santander Media Awards 2016. Email him at columnists@moneywise.co.uk.