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Compound interest is an extremely powerful thing

24/08/2012

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

“The eighth wonder of the world” and “the most powerful force in the universe” are descriptions of compound interest that are often both attributed to Albert Einstein, and while in reality he probably did not say either thing, the fact people are prepared to believe he did illustrates the significance of the concept.

Compound interest – interest earned not only on a loan or investment but also on the interest previously earned – may indeed be a wonder but it is also widely underappreciated so here is an illustration of its power. Given the choice, would you rather have £500,000 upfront or 1p doubled every day for 30 days?

Most people would instinctively take the half a million but compound interest does not work on instinct but maths. Doubling up from 1p on day one, it would be day eight before you had more than £1. After three weeks, however, you would have just shy of £10,500 and, on day 30, your 1p would have become the best part of £5.5m – or £5,368,709.12, to be exact.

Compounding is an extremely powerful thing – especially if you can harness it over time – and you should look to do all you can to ensure you maximise its force to your own advantage. Essentially, that comes down to acknowledging that the earlier you invest and the more you have to invest will maximise the benefits of compounding.

Then, as the pot is building, you will want it to remain as intact as possible, which means ideally avoiding income withdrawals and, particularly, big losses – after all, investing in the market when it grows 8% each year is all very well but, if it should drop 50%, then your pot’s ability to compound will be severely compromised.

So avoiding ‘down’ markets or at least minimising downward moves is of paramount importance and, as it happens, there is an investment strategy that does tick all those boxes. Value investing – as if you had not already guessed its identity – has academically and traditionally proved a support when markets are weak, which is one of the reasons it is, over time, the best-performing investment style.

Author

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

I joined Schroders in 2000 as an equity analyst with a focus on construction and building materials.  In 2006, Nick Kirrage and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Nick and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

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The views and opinions displayed are those of Ian Kelly, Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans and Simon Adler, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated. They do not necessarily represent views expressed or reflected in other Schroders' communications, strategies or funds. The Team has expressed its own views and opinions on this website and these may change.

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