You have a desire to make the most of your money. You know the future won't pay for itself, and you want to start investing into something that can make your money grow over time.
But you face certain problems – the same ones that stop many of us from getting started. Such as:
- You don't have a lump sum to invest
- You're not sure you have a reliable monthly surplus right now
- You don't believe that what you can afford to invest now is enough to amount to anything significant in the long run.
There may be as many psychological hurdles between us and investing as there are encouragements to start.
But if I had understood the effect that compound returns can have on even modest investments, over time, a lot of those hurdles would have been flattened.
You see, a common fallacy is waiting until we feel sufficiently well-off to make a start with the stock market. I know I felt that way throughout my 20s, and even into my early 30s.
That's why I wish somebody had shown me these charts sooner. And it's why I'm sharing them now.
What these two charts demonstrate is the power of making a start. Even a small one. The earlier, the better.
In both the scenarios below, we look at two typical young professionals who start work aged 21 and want to be able to retire by age 70. We assume an annual 7.5% total return (dividends reinvested)*. And we see how their different approaches fare over time.
As always, please remember that investment returns are not guaranteed, values can fall as well as rise and you may get back less than you invest. If in doubt, please take financial advice.
How investing through your 20s can outrun a lifelong investment starting in your 30s
Let's consider two example investors: Alice, and Ben.
Both take the decision to invest £1,800 a year (equivalent to £150 a month) into a Stocks and Shares ISA.
- Alice starts investing aged 21, and keeps paying £1,800 a year into her fund until she's 30. Then, aged 31, other priorities take over, and she stops investing altogether. By that point, she has invested a total of £18,000. She doesn't add another penny.
- Ben starts investing aged 31, having had other priorities in his 20s. He also pays £1,800 a year into his fund, and unlike Alice, he keeps this up for the rest of his working life. So over the next 40 years, Ben invests a total of £72,000 – four times what Alice invested.
Both receive the same assumed long-term total return of 7.5%.
At age 70, who has the greater amount in the pot?
- Alice's investments have grown to £493,954.
- Ben's have grown to £439,741.
- Despite investing just a quarter of the amount and stopping altogether by the time Ben began investing, Alice is over £54,000 better off at retirement than Ben, with just short of half a million in her pot.
You can see from the chart that the secret of Alice's outperformance is her ten-year head start over Ben. Even though she invests four times less than he does – and then does nothing for forty years – she has 20 per cent longer in the market overall, which is the secret of how her investments still outgrow Ben's. (How does that work? – I'll explain further down).
Seeing this chart would have had a profound effect on me aged 21. Instead, I already find myself in Ben's situation: having to work harder to catch up.
Let's look at a different scenario. One that is perhaps more typical of everyday investors.
How £100 regular investments started early can outgrow £300 regular investments started later
This time Chloe and David are our example investors. They follow a more typical pattern: putting away a small amount from their salaries each month.
- Chloe starts her job aged 21 with a salary of £20,000. She begins paying £100 a month (6 per cent of her salary) into a stock market fund.
- David waits until he is on a higher salary to start investing. Aged 40 he earns £36,000 and starts paying £300 a month (10 per cent of his salary) – three times as much per month as Chloe started with – into a stock market fund.
Both these investors increase their contributions by 2% a year to keep pace with inflation. Both receive the same 7.5% annual total return.
By retirement, Chloe has invested a total of £101,495 and David £152,556 – 1.5 times as much as Chloe.
Who has the larger fund to retire with?
- David can retire with a pot worth £532,230
- Chloe can retire with a pot worth £809,139 – 1.5 times as much as David's.
Chloe's much smaller contributions but 19-year head start start means she is over a quarter of a million pounds better off than David at retirement.
What if they both chose to retire early, on their 55th birthday? The difference is even starker: both would have invested roughly the same amount (close to £60,000), but the value of Chloe's portfolio by that stage (£228,243) would be over twice as much as David's (£113,497).
What these charts really tell us…
Both these charts illustrate the power of “growth upon growth” – known in investment circles as compound returns.
This is how compound returns work, and why they're more powerful the longer you stay invested:
- To begin with, your portfolio consists of more or less what you pay into it, give or take any short term market movements
- After a year or more in the market you may have received returns such as dividends, which are added to the pot
- These dividends are reinvested and add to your capital … which then may produce further returns …
- The longer this continues, the steeper the growth curve will be on your portfolio, as you can see from the charts.
You could almost consider compounded investment returns to be free money. Think about it this way: to begin with, you earned your money to invest. This money earned a return. Then that return started earning a return of its own. And so on, year after year.
This is the secret to why Alice's chart stays ahead of Ben's, even though she invests nothing more while he catches up.
Important reality check: your investments could perform better than this, or worse. Stock market returns are variable, can go down as well as up, and you could get back less than you invest. However, having a sufficiently long time frame as discussed here can be one of the best ways to mitigate that risk.
If you are reading this and you're over 30, the message is not that you've missed a chance. These charts could be constructed over any timeframe. I chose 20s and 30s for my comparison simply to prove a point.
The point these two comparisons illustrate is how much harder you will have to run in future to keep up with whatever you could afford to invest now.
So the message to readers of any age is that you have more time now than you will ever have in future. And as these charts show, thanks to compound returns, time in the market can be far, far more beneficial to your wealth than waiting until you have a larger amount to invest.
* You can download my spreadsheet if you'd like to see the working. This will also let you try your own figures, such as a different investment amount or rate of growth.
Just drop me a note over email, say whether you prefer Excel or Google Sheets, and I'll send it to you.