Develop your skills

4 reading time

When you invest over a long time period, the performance of your investments could be improved thanks to a phenomenon known as compounding.

Famously described as the “greatest mathematical discovery of all time” by Albert Einstein, compounding is a term which describes how an investment – when left to grow – can perform surprisingly well over time.

Compounding in action

So, how does it work? Imagine you invested £1,000 in shares in Company A and in the first year the shares rose by 5%. Your investment would now be worth £1,050. In the second year, the shares increase by another 5%, meaning your £1,050 grows to £1,102.50.

Instead of your shares gaining £50 as they did in the first year, they rise by £52.50 because the £50 you earned in the first year also gained 5%.

It may not sound like a huge difference, but the numbers increase exponentially over time. If you kept your £1,000 invested for 30 years, and it increased by 5% every year, it would more than quadruple to £4,467.74 – and that’s without you investing any extra money.

Why reinvesting works

The above example looks at what happens to your money when you keep the original amount invested and the share price rises by a steady 5% every year.

However, you could also reinvest any dividends that the company pays you each year as a reward for holding their shares. This would further intensify the compounding on your money because, in a rising market, it creates a snowball effect.

The more that you reinvest your dividends in additional shares, the more shares there are to pay you dividends.

Growth on growth

If companies continue to do well, they tend to increase their dividend in every consecutive year. This means, as the actual amount of dividend increases, so do the benefits of reinvesting these payments.

Take, for instance, an investor who decided to put £1,000 into shares in the FTSE-100 in 1986 – a time of deregulation that opened up the stock market to individual investors.

By simply holding onto their shares for 30 years and reinvesting the dividends, their initial investment would have grown to nearly £12,700. Of course, this is the best case scenario: it’s also possible that if a company is struggling, it may reduce its dividend or even cut it altogether.

The power of compounding also applies to any money you invest in an ISA or pension. These tax wrappers allow you to protect your money from UK income tax and capital gains tax. Pension contributions attract tax relief from the government, providing a further boost to your savings. The amount of tax relief you get will depend on what rate of tax you pay.

Compounding only works if you leave your money untouched, and the effects are noticeable if you invest over a long period of time. To find out more about the case for buying and holding investments, read our article here.