This is an audio transcript of The Five Minute Investor podcast episode: ‘The Five-Minute Investor from Money Clinic — The power of compounding’
Claer Barrett
Can you speak the language of money or are you one acronym short of an investment picnic? Too often, financial jargon prevents us from making the most of our money. But this podcast from the Financial Times is designed to make you smarter and hopefully richer in just five minutes. Welcome to the Five Minute Investor from Money Clinic. I’m Claer Barrett, the FT’s consumer editor, and I’ll be teaching you what you need to know about key investment terms in the time it takes to unload the dishwasher. Each week we take one investment term, selected by our listeners, and challenge a top investment commentator to defang the financial jargon in just five minutes. Joining me in the studio this week is University Challenge alumnus, maths teacher and fellow broadcaster Bobby Seagull. Welcome, Bobby.
Bobby Seagull
Delighted to be on the pod.
Claer Barrett
Well, the topic that I want to quiz you on this week — with no deviation, repetition or hesitation — is compounding. Now, to start off with, can you give us your five-second definition, please?
Bobby Seagull
Compounding is a secret of how you grow the value of investments significantly over time.
Claer Barrett
Sounds intriguing. Well, as I set the timer, Bobby Seagull, could you please tell us more about the power of compounding starting now?
[TIMER TICKING]
Bobby Seagull
Well, it’s the closest thing we have to a magic money tree. And Benjamin Franklin best described it as money makes money, and the money that money makes, makes money. And it allows money to grow exponentially over time, can help savers and investors turn small capital sums into large cash piles over many years. So get your winter jacket on. We’re going out. We’re getting some snow. We’re building a snowball. And you know, when you push a snowball down a hill, it continuously picks up snow and then becomes like a gigantic snowball when it reaches the bottom of the hill. And that snowball effect is essentially a good analogy for compounding, because small actions can lead to big gains over time.
Claer Barrett
So, Bobby, how does compounding work when it comes to our investments?
Bobby Seagull
So investment is making money in two ways. There’s the capital growth, almost like the share price increase, or there’s the income that the investment produces at the dividends. And just like the interest in your savings, you could take the dividends and spend them, or you could reinvest the dividends and use them to buy more investments. And this is how investments can compound.
Claer Barrett
OK. So give us an example with some numbers but make it easy to understand.
Bobby Seagull
OK. So let’s say you invest £1,000 every year.
Claer Barrett
Every year.
Bobby Seagull
And you assume an investment growth of 10 per cent growth per year.
Claer Barrett
That’s quite high, but I see what you’re doing with the zeros.
Bobby Seagull
Yes. So you could take the dividends out. But if you reinvest, the money grows bit by bit over time. So after 10 years you double your money to 20,000.
Claer Barrett
OK. How about a longer period?
Bobby Seagull
Let’s say 40 years. It actually grows to — wait for this — just over 600 grand.
Claer Barrett
Well, so that’s £1,000 every year for 40 years, £40,000. But the power of reinvesting those dividends, assuming 10 per cent growth a year, it would get you to that.
Bobby Seagull
The real impact of the snowball.
[TIMER TICKING]
Claer Barrett
OK, so how can I harness the power of compounding in my own portfolio? I’m unlikely to get 10 per cent a year, but you would hope over time I’d average maybe 5-6 per cent a year.
Bobby Seagull
Exactly. So if you’re owning shares, including shares and investment trusts, most investment platforms actually allow you to tick a box: please reinvest my dividends. And it will be done automatically.
Claer Barrett
Simple.
Bobby Seagull
Exactly. And if you hold funds or index trackers when you buy your investment, you’re not actually buying the shares. You’re buying units in the fund. And you’ll be asked to choose between two types: INC, I-N-C, or ACC.
Claer Barrett
OK. Explain what INC and ACC are.
Bobby Seagull
The INC stands for income, and means any investment income is paid out to you and you decide what to do with it. And ACC, A-C-C, stands for accumulation, and this means any investment income will be automatically reinvested.
Claer Barrett
OK, so nice and easy for investors, but how can we push the power of compounding to the max?
Bobby Seagull
So this is where time is your friend and you want to maximise the duration or the investment period. And you can use things like tax wrappers like ISAs and pensions so that valuable growth is protected from the tax. And when you think about pensions, which is very good for compounding, given the length of time you’re gonna be saving into pensions, decades, you’re gonna get the extra money we’ll give you. And that’s going to be particularly potent with compounding.
[TIMER TICKING]
Claer Barrett
OK. Now, can you give us some examples of how compounding works against you? Because it’s not a force that’s always working in our best interest.
Bobby Seagull
So you don’t want to be standing in the way of a snowball either when it grows. So the interest charge on credit cards and other forms of borrowed money. Actually there’s a great example that Martin Lewis has about the credit card. So let’s say you borrow three grand at the age of 21 and you only make the minimum repayment. You’re gonna be almost 50 before the debt clears and you have paid thousands of pounds in interest.
Claer Barrett
And that’s because the power of compounding is working against you. All of those little payments of interest on top of the interest, instead of that being something you were earning, is something you’re owing.
Bobby Seagull
Exactly. And that’s why any listener, we always tell them, you always pay down the most expensive part of the debt first. And like look for flexible loans, which can allow early repayment.
Claer Barrett
How else can compounding work against us?
Bobby Seagull
So when you think about investment fees. These can grow over time and they erode the value of your investment returns. And when you’ve got large sums to invest, the flat fees can actually be better value than the percentage fees in the long run.
Claer Barrett
Now, why might compounding be a comforting force for younger listeners, in particular, to hear about?
Bobby Seagull
Because again, it’s the time impact, because the effects of time are drastic. So even if you invest in quite small amounts over time, that really makes a huge impact. So the thing is, you need to be consistent, invest in the most tax-efficient way, think about your fees, but your money will grow over time.
[TIMER STOPS AND ALARM SETS OFF]
Claer Barrett
Well, the sound of that timer means that, Bobby Seagull, your five minutes are up.
Bobby Seagull
Gone so quickly.
Claer Barrett
Was it harder than University Challenge?
Bobby Seagull
You’re nicer than Jeremy Paxman.
Claer Barrett
Well, thank you for explaining the power of compounding to our listeners with no deviation, repetition or hesitation. We firmly believe on Money Clinic that there are no stupid questions about money. The only stupid thing would be not to ask one if there’s something you don’t understand. So if there’s an investment term, a piece of jargon, or a phrase you’ve heard that’s baffling you and you’d like me to unpack it in the studio with an expert, then get in touch with us. Our email address is money@ft.com. Or you can find me on Instagram and TikTok. I’m @ClaerB. Brand-new Money Clinic episodes will be coming soon. And if you can’t wait until then, have a browse through our back catalogue where you can find hundreds of episodes or click on my suggestions in today’s show notes.
Finally, the Five Minute Investor is a general discussion around financial topics and does not constitute an investment recommendation or individual financial advice. For that, you’ll need to find an independent financial adviser. Tune in next week for another Five Minute Investor. Goodbye.
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