Do YOU know how compounding works? Here’s how it can turbocharge your Isa

Do you understand how compounding can massively boost your savings and investments? The vast majority of us do not grasp the simple maths that can make our fortune, a new survey reveals.

Just 28 per cent of people could work out how much money they would have if they invested £10,000 for a year, with the investment growing at 8 per cent and compounded daily, according to research from Hargreaves Lansdown.

Most people expected the investment to reach £10,800, but it would grow to £10,832 over the course of a year. 

That might sound a small difference but it is far from the end of it, as the ‘growth on growth’ – the compounding – can turbocharge returns over time.

Based on 8 per cent returns, with no extra capital heading in, over two years the £10,000 investment would reach £11,729, rising to £12,702 over three years and £13,757 over four years.

In the long term though, the effects of compounding are even more starkly in your favour. 

Over the course of ten years the figure would reach £22,196, rising to £49,268 over 20 years. If the money was left for a 30 year period, the investment would be worth £109,357.

In comparison, if the same £10,000 earned £800 per year for 30 years it would reach just £34,000.

> The tale of Prudence and Extravaganza: Scroll down to find out how two sisters who saved early and late in life ended up with vastly different outcomes…

Some 31 per cent of men answered correctly, compared to 25 per cent of women who took the Hargreaves maths test. 

Older people were more likely to get their calculations right, with 38 per cent of people aged 55 answering correctly.

Most people might have neglected their maths revision since leaving school, but understanding how the effects of compounding work reveal the benefits of investing your money early and in the right place. 

You don’t even need know how to do the actual sums yourself – just grasp the importance of earning interest on your interest year after year in a savings account, or reinvesting dividends and making returns on your returns over a long period of time, then go off and do it.

Joseph Hill, senior investment analyst at Hargreaves Lansdown, said: ‘There are three things that matter when it comes to compounding. One is that the more frequently growth is added, the bigger the impact of compounding, because you get growth on that growth immediately.

‘With savings you may get interested added daily, monthly or annually. With investments it tends to be daily.’

The second key consideration, according to Hill, is to ensure that your investments have considerable time to achieve as much growth as possible.

He says timelines should be measured in years rather than weeks.

In general, the advice is that you should invest for at least five years in order to allow your money to grow. This also helps to reduce the impact of short-term market fluctuations.

Hill said the third consideration is to put your money somewhere that offers a fast rate of growth.

Even with cash savings accounts currently offering high rates of interest, choosing to invest your money is likely to deliver significantly higher returns.

Historically, this has long been the case, though there is of course no crystal ball.

‘Typically, you get faster growth over the long term from investments than from cash savings, so you get more compound growth,’ Hill added.

Hill tips Artemis Income fund (ongoing charge: 0.81 per cent), which he says will make the most of UK income opportunities.

Artemis invests mostly in UK large caps that are likely to pay a sustainable income regardless of the economic backdrop.

‘These tend to be businesses with lots of reoccurring revenues. This increases the chances they can retain and grow their customer base, profits, and dividends over time,’ Hill said.

This income is reinvested to make the most of the compounding effect. Artemis Income has delivered 48.69 per cent growth over five years.

Hill also tips Fidelity Global Dividend fund (ongoing charge 0.92 per cent). This fund focuses on global firms with predictable revenue streams and reliable dividends.

Fund manager, Dan Roberts, ‘keeps a close eye on company’s valuations, ensuring he doesn’t overpay, but will also not chase the higher yielding areas of the market if he thinks they are overvalued, or the dividends aren’t as reliable as he’d like,’ Hill says.

The fund has grown 55.54 per cent over the past five years.

Prudence and Extravaganza: How much will each have to retire on? 

I like to tell the story of two sisters, writes Fidelity International’s investment director Tom Stevenson, who has written a guide to compounding for This is Money.

One starts putting aside a modest amount when she is just 18 years old. (She’s called Prudence, obviously.) Saving £20 a week gives her £1,000 a year.

Again let’s assume a combination of capital growth and dividend income gives her 10 per cent a year. Not only does she grow her initial investment by 10 per cent every year but she also adds in a new £1,000 each year too. 

The results are pretty amazing. By the time Prudence is 38 she has accumulated £63,000.

Now Prudence’s sister (I call her Extravaganza for obvious reasons) laughs at her careful sister and spends the 20 years from 18 to 38 enjoying herself and spending all her money. 

But aged 38 she sees how much Prudence has put aside and she thinks she would like to match her. She too starts saving £20 a week and earns the same 10 per cent as her sister.

But here’s the rub. Because she starts later and doesn’t benefit from the miraculous ingredient of time, she never catches her sister up.

When they are both 60, Extravaganza has accumulated just £80,000 compared with her sister’s half a million. And with every year that passes their fortunes diverge even further. Read the full story of Prudence and Extravaganza here.