We recently attended a meeting of company pension fund trustees where the chairman felt the need to clarify one observation with the line: “And, of course, because of compounding, a 10% increase in performance every year for five years means a total increase of not 50% but 61%.”
A valid point, no question – but an odd one to be making, we felt, to a group of professional custodians of a sizable amount of money.
Clearly the concept of compounding – the interest or growth earned not only on a loan or investment but also on the interest or growth previously earned – is not one everybody finds easy to grasp.
As we have illustrated in articles such as How realistic is a £1m pension pot? and indeed Compound interest is an extremely powerful thing, however, it is well worth making the effort to do so.
Given the 2018 World Cup kicks off today, it seemed appropriate this time to emphasise the power of compounding with a football example – specifically, the current holders Germany, who qualified with a 100% record of 10 group wins out of 10.
Even now they're second favourites with the bookies to win the tournament (after Brazil) let’s say they go on to win all their group and knock-out matches en route to lifting the trophy in Moscow on 15 July.
OK, modern history may be against them as no team has retained the World Cup since Brazil in 1962 but it is just theory and, if Germany do win those seven games, that would make 17 in a row this campaign.
So, here’s the question – if, when Germany kicked off their first match on 4 September 2016, we had offered you £1 and doubled your total pot each time they won or a £50,000 lump sum upfront, which option would you have picked?
Most people would instinctively take the £50,000 but compound interest does not work on instinct but maths.
Doubling up from £1 after Match 1, it would only have been Match 8 before you had more than £100.
By the end of qualifying (Match 10), however, you would be up beyond £500 and after the World Cup final (Match 17), you would have more than £65,000.
|Match||Total (compounded)||Total (fixed)|
Extend that idea over the course of a full Premier League season (whichever team you like – winning all 38 games really is in the realms of fantasy football) and how do you feel about a choice between the same £1 doubled each time or, say, a cool £10bn upfront?
If you picked the compounding pound this time, you were right to do so and have theoretically pocketed some £140bn – or £137,438,953,472 to be precise.
Almost enough to buy an entire back four for Manchester City, as the wags might say – but certainly clear evidence of why, away from the realms of theory, investors should give their assets as much time as possible to reap the very real benefits of the power of compounding.