Patience is a virtue, and this old adage also applies to investors. Those who make a return on their investment can also then make a return on their return, a concept known as compound interest. And while it may not seem like much at first, this effect can at times be so large that even Albert Einstein called it the eighth wonder of the world.
If you keep your money invested for a long enough time frame, it becomes possible to not only make gains on the initial investment, but also on previously made returns. If your returns are positive, and seen over a long enough time frame, the impact of compound interest will lead to increased returns.
To illustrate the point of compound interest we assume averaged and positive returns every year. Note that in practice, losses can also be incurred when investing. Let’s say you invest €5,000 and get an average return of 7% per year. At the end of the first year, this investment will earn you €350. If this is reinvested and same rate of return of 7% is assumed, your gain the following year will increase to almost €375. Each year, the invested amount will increase, as previous gains will contribute to a higher return.
The compound interest creates a snowball effect; the longer the money is left invested, the more your initial investment will increase year after year. In this example, with an initial investment of €5,000 at age 25, you will receive an annual interest of almost €700 when you are 35. But later, at the age of 65, this is increased to over €5,000 a year, all without a single addition to the initial investment.
This effect does not only apply to your returns but also factors that can impact your returns; namely, the fees you pay your broker to trade. As small gains can become much bigger gains thanks to compound interest, the fees you pay now can have a substantial impact on your returns even years down the road.
Take again the example of investing €5,000 at age 25 with an annual average return of 7%. By 65, your portfolio would grow to almost € 75,000 just from the yearly returns. To maintain this portfolio though, your broker will charge you something. Let’s say you pay €25 per year in broker costs. Over a 40-year period, this would imply that you pay €1,000 in fees. However, as this amount can no longer generate interest, it causes your portfolio to be about €5,000 less in the end.
Suppose these costs are a bit higher, at €125 per year. This seems like a small difference but the end result is dramatically lower, less than € 50,000. In the end, although the costs were €125 per year, the missed returns at the end come down to an average of €625 per year.
Therefore, it makes sense to consider and compare the fees that brokers charge. This can save you a lot of money over time. DEGIRO offers incredibly low fees. A comparison between brokers can be found on our fee page.
In our final lesson, there will be an overview of what you should consider when putting together an investment plan. There is an overview of various investment goals you can set, and the corresponding strategies to get you there.