Compound interest is over-rated

When people wax lyrical about the power of compounding, they like to tell an 11th century story about a clever inventor who asks the king to pay him by placing one grain of rice on the first square of a chess board, then doubling it on each successive square. The king laughs at what a great deal this is… not realising that after 64 doublings, he will owe eighteen quintillion grains of rice.

A more modern (and actually true) story that’s often used to make the same point is that Warren Buffet – one of the wealthiest people in the world with a net worth of some $114 billion – made 95% of his wealth after the age of 65, even though in recent decades he’s not done much other than sit around reading and drinking Cherry Coke.

But for most of us, compounding won’t be the answer to all our financial prayers. 

(I recorded a 2-minute video about this concept too.)

Let’s set up an example to find out why:

• You start at 20 years old
• You’re earning £30,000
• You invest 10% of your salary
• Your salary increases by 5% per year, and so do your contributions
• Your investments return an average of 5% per year after inflation

In the first year you put in £3,000, and earn a return of £150. Big deal.

But by the time you turn 60, something incredible has happened. You’re now contributing £20,000 per year into investments – and those investments are now producing returns of £40,000 every year. All in all, you have investments worth £844,252 – of which you put in less than half, and the majority came from your investment returns.

This sounds like an incredible outcome: your money is now earning more than your starting salary every year, without any effort on your part. And all based on a very modest level of contributions.

(In reality you would probably have increased your contributions by more as your income grew, but it makes the example too complicated. Instead, we can assume that you were also busy buying and paying off a house, and using your money in the present to have a good time – which there’s nothing wrong with at all.)

So: 60 years old, all great. But let’s check in on where you’d be at the halfway mark of 40 years old, after executing this plan for 20 years.

At this point, nothing that special has happened at all. You’d be generating £7,484 from a total investment pot of £161,359, of which over £102,000 – two thirds – was money you put in yourself.

So if you decided after 20 years that the corporate world wasn’t for you and you wanted to take a step back to try starting a business, or even if you were forced to stop working due to illness or family commitments, that £7,484 of investment income wouldn’t help you much.

And of course, we’re assuming here that you started at the age of 20. What if you didn’t actually start until age 40? Not an unreasonable assumption, given that you may have started earning later, been saving up for a house, or just not spending your free time reading personal finance books so you never thought to get started. Well in that case, you’d reach age 60 – a time when you might be wanting to ease off a bit – with only that £7,484 in investment income to support you.

This reveals the unfortunate reality of compounding: it’s all back-loaded. For the first couple of decades, the vast majority of the growth in your investment pile is coming from your own contributions – and it’s only after 30 years or so that the “interest on interest” starts building up in a meaningful way. In our from-20-to-60 example, a full quarter of the investment pot ended up being accumulated in the last five years alone.

This is still great if start young and go on to enjoy a Buffet-esque lifespan, but it makes no practical improvement to your life until after you’ve gone grey.

So what’s the answer?

Well, compounding is too powerful to ignore completely. I believe you should set up a compounding machine as early as you can – and base it on a realistic level of returns. (I see 10% being bandied around all the time, but there’s no chance a truly diversified portfolio will produce anything like that amount after inflation – I reckon 5% is optimistic.)

Once you run the numbers (which you can do with a simple calculator like this one), is that going to get you to where you want to be? If so – and you’re willing to wait that long to get there – that’s brilliant. No further action needed.

But if you’re dismayed by the outcome, or you want to start upgrading your life without waiting for decades, then you’ll need to layer something else on top. That could be starting a business, creating non-financial assets (books, courses…), investing more actively in an area where you have expertise, or anything else that has the potential to pay off bigger and sooner.