What are the effects of Long-term Investing on Compounding Interest?

February 27, 2024
2:19 pm

We all know the tale of the tortoise and the hare. The hare had speed and raced ahead but got distracted while the tortoise progressed slowly and steadily to win the race.

When it comes to investing, saving or wealth building, time is the secret weapon. Long-term investing earns compound interest that could exceed the original capital investment if given enough time.

What is Long-term Investing?

This is investing over several years, like 7-10 years or longer. This method of saving builds capital and earns interest. A retirement savings plan or annuity is a typical long-term investment spanning 30-40 years. Long-term investment smooths out the volatility in the market. This investment period uses time to build capital and gain valuable compound interest. This is one of the best ways to save for retirement through a private pension plan or retirement annuity.

Example of long-term investing

John starts saving £300 a month, earning an average interest rate of 6% annually. He begins at age 25 and retires at 65. Over 40 years, he will have saved up around £600,000.

Suppose John started saving for retirement at age 35. That’s 30 years till retirement at age 65. He would have saved up only half at around £303,000. Ten years means the difference between doubling his retirement money. He would have to increase his monthly contributions to £600 to achieve the same savings if he saved over 40 years.

It’s all about ‘time in the market’ instead of ‘trying to time the market’.

What is a Regular Contribution Saving?

This means saving money on a regular basis to build capital. This usually occurs monthly and can be anything from short to long-term. By buying stocks monthly instead of trying to time the market, you can take advantage of unit cost averaging.

This technique invests in units of funds or stocks gradually. This way, you can take advantage of the volatility of markets. By slowly investing in units or stocks, you usually buy more units than if it were a lump sum investment. This will ultimately increase value over the long term.

Example of regular contribution savings

A regular monthly contribution of £300 over 30 years with an annual interest rate of 6% could add up to around £303,000. The capital contributed would be around £108,000 while compounding interest a whopping £195,000.

Types of Regular Contribution Savings

Retirement annuity and private pension plans – These are designed for regular contribution savings over the long term and aimed specifically at growing capital for retirement.

High yield savings account – These accounts earn above average interest on deposits. They could earn up to ten times more interest than regular savings accounts but could have fixed periods attached to them, preventing any withdrawals like a 5-year fixed saving period.

Education savings plan – These are long-term savings plans to grow capital for your children’s education.

Advantages of Regular Contributions

In control of your money – Contributing regularly to an investment gives you financial peace of mind, knowing you are growing your money and building a nest egg.

Building capital – Earning interest on interest over the long term boosts your capital.

Varied timing – This helps reduce investment risk. Regular contributions do not worry about timing in the market. It buys units on a fixed day every month. This will, over time, obtain an average stable price.

Boosts financial health – Regular contributions supplement your future saving plans and give you peace of mind. No more worrying about saving as contributions are deducted automatically for your convenience. This healthy habit of saving regularly boosts your financial security and motivates you to save even more.

What is Compounding Interest?

Compounding interest is interest on interest. For example, when you save money, you earn interest on your capital. This increases your overall capital, and when you earn the next lot of interest, it will be on the new capital amount, thus increasing interest. You receive 10% interest on £100 of £10 = £110. The subsequent interest will be based on £110, which is £11 = £121. Each time your investment earns interest, it is a higher amount. Eventually, over the long term, your interest earned might exceed capital. This is why Warren Buffet considers compounding interest the 8th world wonder.

Example of compounding interest

A £10,000 investment over 30 years at an average annual interest rate of 6% could add up to around £303,000. That’s over £40,000 in compounding interest. It would take around 11 years for the compounding interest to exceed the original capital invested.

Long-term investing and compounding interest go hand in hand and are two of the best ways to build wealth over the years. A financial advisor can help incorporate regular contribution savings into your financial plan and goals. Slow and steady wins the financial security race.

Please note, the above is for educational purposes only and does not constitute advice. You should always contact your advisor for a personal consultation.
* No liability can be accepted for any actions taken or refrained from being taken, as a result of reading the above.