Compound interest: The 8th wonder of the world

Albert Einstein once described compound interest as the eighth wonder of the world. “He who understands it, earns it … he who doesn’t … pays it,” he famously said.

For investors, compound interest represents one of the best ways to build wealth with minimal effort.

What is compound interest?

Compound interest simply means that after you make your initial investment, you commit to reinvesting any interest earned year after year. If you have invested in a fixed return product, or in an investment portfolio which pays even a small amount of interest each year, these compounded returns can quickly add up.

For example, if you are earning five per cent per annum on an initial investment of £1,000, reinvesting the interest each year and assuming no losses, by the end of year one you will have earned £50 in interest, bringing your overall portfolio to £1,050.

During year two, you will earn five per cent on £1,050, rather than your original £1,000. This means that by the end of year two, you should have a portfolio worth £1,102.50.

If you continue to reinvest any interest, by the end of year ten, your portfolio could be worth approximately £1,628.89. That’s over £628 in interest, from a one-time investment of £1,000.

If you are topping up your account on a regular basis, the amount of money earned through interest will be even higher, and compound interest can accrue at an even faster rate.

How to make the most of compound interest

Any investment can benefit from compound interest, but the best results could come from fixed-rate products such as bonds, savings accounts and peer-to-peer loans.

However, it is important to remember that not every investment will result in annual returns being paid. For example, investments in the stock market can lose money during times of macro-economic stress. The past few years have shown us that the stock market is capable of exciting highs and crushing lows. While this can make it an appealing market for traders, it is not necessarily an attractive option for investors seeking to earn compound interest.

Compound interest rewards consistent returns, even if they are small. A small return every year could do more good for the overall size of an investment portfolio than the peaks and troughs of the stock market.

Of course, every investment comes with risk. In P2P lending, the key risk is the possibility of defaults due to borrowers being unable to repay their loans. While P2P platforms work hard to minimise this risk for investors, there are no guarantees and losses do occur, particularly during an economic downturn. While P2P lending has a track record of delivering relatively stable returns, past performance is no indication of future success, and investors are always encouraged to do their due diligence before making any new investment, and to maintain a diversified portfolio.

Having said that, where fixed returns are available, the possibilities for compound interest are compelling. Over time, compounded returns can add a huge amount of extra value, without the need for ongoing investments.