The 'stepping stone' investment method can help you increase your savings exponentially over time
We all know that having a healthy savings pot is a good thing. But building one can be easier said than done.
After bills, the mortgage and day-to-day spending is accounted for, many of us find there is very little left to set aside.
However, there is a way you can make your savings – no matter how small – work much harder for you.
Let’s call it the “stepping stone” approach. It could leave you much better off.
The concept behind this method is simple: you start by putting a set amount aside each month and, every year, increase it by 10%.
So, for example, let’s say you start by saving £100 a month. After a year, you increase this by 10% to £110. Then, in year two, you increase it to £121, and so on.
This approach can work well no matter how you save, whether you decide to invest in the stock market or you put your money into a standard savings account.
Investors often achieve better returns than those who opt for a standard deposit account, research we conducted this year found. This is particularly true since the financial crisis, as rates are now at near record-low levels.
So, with this in mind, we decided to look at what would happen if you had started using the stepping stone approach 20 years ago.
Let’s assume you started by investing £100 a month into the FTSE All Share, a well-known investment index, and increased this by 10% every year.
In this example, you would be left with a whopping £108,020 now, after typical investment fees of 1.4% have been deducted, although of course the value of investments can go down as well as up and you could get back less than you paid in.
While the past performance of the FTSE All-Share is no guarantee of how it will perform in future, generally speaking equity markets go up over time.
If, on the other hand, you had decided to keep investing £100 a month for the whole 20 years, you would be left with £43,375 – some £64,645 less.
Of course, not everyone is able to save £100 a month, but that doesn’t matter. The beauty of the ‘stepping stone’ approach is that it works no matter how much you are able to set aside.
For example, let’s instead assume you started investing £10 a month and you increased that amount by 10% every year.
In this scenario, you would had invested £11 a month in year two, £12.10 in year three and so on.
After 20 years, this would have left you with £10,802 if you had increased your monthly investments by 10% a year.
However, if you kept saving into a typical deposit account, rather than investing £10 a month for the entire 20 years, you would be left with just £4,338 after fees. That’s £6,464 less.
But why? When you use the stepping stone approach, you might benefit from the wonder of compound interest. Essentially this means that because you are buying new investments every month, you earn returns on these in addition to the return you achieve on your original investments. This boosts your overall profit.
On top of that, because the increases are gradual, you are less likely to miss the extra money you’re setting aside.
It also goes to show that you don’t need large sums of money to achieve good investment returns.
Even if you start small, the stepping stone approach could help you build up a sizeable nest egg for the future.
Kevin Brown is a savings specialist at Scottish Friendly
The information in this article does not constitute advice or necessarily reflect the opinion of Moneywise. Investing carries risk and past performance of investments does not guarantee future growth.