It is often said that Einstein declared compounding the most powerful force on earth. While the authenticity of this quote is debatable there is no denying that compounding is extremely potent. It is also something that investors often overlook – or underestimate – when thinking about putting away money over the long term. Here we look at the ways in which compounding can influence the performance of your ISAs and ultimately help you reach your investment goals.
Time is money
Our chart illustrates the impact of compounding over time and helps drive home the message that investing regularly does add up. It focuses on two investors: Mo and Flo. Mo has managed to invest £100 on a monthly basis over 40 years while Flo came to investing later but chose to invest a larger sum of £250 a month. Both received an annual return of 5% compounded monthly.
The impact of compound growth
Source: Bestinvest. This image is for illustrative purposes only.
Smoothing out volatility
Regular investing over time also helps smooth out the highs and lows of markets so during a prolonged bout of volatility such as now, it can make real sense. If you were investing a lump sum, you’d be committing it all to the market at the same time. This might work well for you but buying into markets at the right time is notoriously difficult not to mention extremely stressful and if you get it wrong you could suffer.
With regular investing, your money is drip fed into the markets meaning you don’t end up buying everything on the same day at the same price. Instead, when prices are low your money buys more and when they rise, you get less. This is known as ‘pound cost averaging’.
Regular investing into an ISA
You can continue investing into an ISA throughout your life, and while there is a set annual contribution allowance, there is no limit to the size an ISA portfolio can grow to. The long time horizons of ISAs mean that they are very well suited to regular investing because they can give compounding the opportunity to really take root. With ISAs, your investments grow free from Capital Gains Tax and Income Tax which helps boost the effects of compounding even further.
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