Called by some ‘the eighth wonder of the world’, compound interest (also known as compounding growth or compounding returns) is the interest your investment earns, as well as the interest your returns earn over time. This means your money can potentially earn more money over time when your returns start gaining interest too. Sound interest-ing yet? 

Compounding interest takes time and requires being a patient investor. When you understand the impact that compound interest can have, the benefits of long-term investing can speak louder than the day-to-day market headlines.

We’re big advocates of long-term investing here at Hatch, so how does compound interest work? And what can it mean for you?   

How compound interest works in investing

Let’s jump straight in. Say you invested $1,000, based on an average return of 10% a year, which is the historical average percentage return for the US share markets since the 1950s, this is how the growth of that $1,000 could have compounded over time:

‍

‍

With the same 10% annual return, the value of the returns grow more each year because not only are you earning interest on the initial investment, but you’re also earning interest on the returns gained. It’s kind of like a snowball rolling down a hill picking up more snow on its journey. 

This is where time can have a huge impact, and the numbers on that long-term horizon get exciting! 

For example: If your parents had made just a one-off investment of $1,000 in 1970, and received an average 10% annual return, by the year 2000 - 30 years later - it could have reached a total of $17,449.90. That’s a return of $16,449.90 without investing a single cent more than that initial $1000!

And if you’d had the opportunity to invest that $1,000 65 years ago, with a 10% annual return, it could now have grown to $1,000,356.28 without ever adding to that initial investment. Now, that’s a kind of magic! 

Ready to have your own spin of the magic? Try experimenting with compounding growth yourself using Sorted’s compound interest calculator.

‍

In the short term, it's hard to predict whether - or how much - the share markets may increase or decrease in value - share prices are naturally volatile and go up and down regularly. This may mean that leaving your investments as long as possible gives the best chance of compounding returns to do their work, and for your investment to ride out the bumps in the market.

Take a look for yourself. Google the share price for large, well-established companies - or search in Yahoo! Finance - and look at the share price over a long period of time - ‘Max’ (for maximum). The share price goes up and down over the short and even medium term. But in the long run, over decades, the graph line typically points up for mature companies.

‍

Compounding interest works - even with some bad years

If you’re wanting to reap the rewards of compound interest, you’ve got to be in it for the long-term. This is because while there may be a few bad years when you see a negative return - yep, recessions come and go - compounding growth can still work when you’re in it for the long run. 

Using that same $1,000 investment, let's run the numbers again based on the average returns of the S&P 500 over the past ten years and create our own compound interest calculator:

‍

‍

In 2020, there was a -18.01% return and just over $700 was lost - ouch! But does it really matter over the long term? The investment had tripled in just 10 years and was still worth $2,229.16 more than was invested. 

Always remember, even if your investment dips below what you paid for it, you never actually make or lose money until you sell your shares! 

And to prepare for any bad year, at Hatch we always reckon it’s a good idea to keep that emergency fund topped up so you’re not tempted to sell down your portfolio and miss out on the magic of compounding returns. So let’s talk about the difference between saving and investing and how you don’t need to choose between one or the other.

Saving vs. Investing

When should you use a savings account, and when should you invest? Compounding growth works the same way in an interest-bearing savings account as it does with investing. But the major difference between the two is consistency of returns. And knowing this could be the difference between reaching your goals or saving yourself poor.

Savings Account

Compounding growth works on your money in savings the same as your investments. The big difference is when you put your money in a savings account, the interest you gain has been typically lower than return for the US share markets. Savings account interest in New Zealand sits between 0.05-5.50% versus the 10% historical average percentage return of the US share markets.

For example, if you had $1,000 in a term deposit at a 3% interest rate for one year, the total amount would have grown by 3% = $1,030, a gain of $30.

But sometimes even the best interest rates available can be lower than inflation. This means even with compounding growth, your money may have been decreasing in value over time when compared with any rises in inflation and the cost of living. 

Savings account interest rates do fluctuate but they are considered more stable than the share markets. Savings accounts can play a very valuable role in helping you to reach your financial goals. They’re a practical place to keep money that you may need to access quickly to use immediately or in the near future. A savings account could be used as your emergency fund, or for when you’re saving for a specific thing such as a car or a house deposit. 

Investing

As the tables show above, historically the share markets have increased in value by an average of about 10% every year. But as they also show, they don’t increase every year. An investment may grow by 30% in one year, 2% in the next year and drop -10% the year after. But even based on this example of rises and falls, you’d still see an average return of 7%. 

Investing for the long term means you’re better placed to ride out any dips in the market - the longer you leave your investment, the longer you have to bounce back from any falls, and the higher the average return you can potentially gain. But if you think you’ll need to access your money held in investments any time in the near future, you may be at risk of losing some of your investment in a shorter period of time if the market or your stocks are down at that time.

Read more in our guide to savings vs. investing.

Compound interest summary

As we’ve covered, while the share market has gone up and down every year, the average historical return has been 10%. Bear in mind too that individual company shares might have short (or even long) periods of higher growth, or they could even end up worth nothing at all! So always do your research and learn about diversification and how spreading your money across a range of investments may lower risk.

It may also help to remember that while bank accounts typically offer a fairly stable, predictable small return in the short term, that predictability (and inflation) could cost you in the long run.  While the effect of compound interest in the share markets can take much longer, the best way to let compound interest work its magic is by giving it time.