Develop your skills

Learn how to develop your investment knowledge.

Why compounding matters

  • 3 min reading time
Boxer training with teacher

When you invest over a long time period, the performance of your investments could be improved thanks to a phenomenon known as compounding.

What you will learn

  • What 'compound interest' means
  • How compounding increases the value of your investments
  • Why long-term investment is powerful

Famously described as the "greatest mathematical discovery of all time" by Albert Einstein, compounding is the process by which an investment – when left to grow – can perform surprisingly well over time.

Compounding in action

So, how does it work? Imagine you invested £1,000 in shares in Company A and in the first year the shares rose by 5%. Your investment would now be worth £1,050. In the second year, the shares increase by another 5%, meaning your £1,050 grows to £1,102.50.

Instead of your shares gaining £50 as they did in the first year, they rise by £52.50 because the £50 you earned in the first year also gained 5%.

It may not sound like a huge difference, but the numbers increase exponentially over time. If you kept your £1,000 invested for 30 years, and it increased by 5% every year, it would more than quadruple to £4,467.74 – and that's without you investing any extra money.

The reinvestment effect

The above example looks at what happens to your money when you keep the original amount invested and the share price rises by a steady 5% every year.

However, you could also reinvest any dividends that the company pays you each year as a reward for holding their shares. This would further intensify the compounding on your money because, in a rising market, it creates a snowball effect.

The more that you reinvest your dividends in additional shares, the more shares there are to pay you dividends.

Growth on growth

If companies continue to do well, they tend to increase their dividend in every consecutive year. This means, as the actual amount of dividend increases, so do the benefits of reinvesting these payments.

Take, for instance, an investor who decided to put £1,000 into shares in the FTSE-100 in 1986 – a time of deregulation that opened up the stock market to individual investors.

By simply holding onto their shares for 30 years and reinvesting the dividends, their initial investment would have grown to nearly £12,700. Of course, this is the best case scenario: it's also possible that if a company is struggling, it may reduce its dividend or even cut it altogether.

Did you know?

Even investing a small amount of money is worth it in the long run.

The power of compounding also applies to any money you invest in an ISA or pension. These tax wrappers allow you to protect your money from UK income tax and capital gains tax. Pension contributions attract tax relief from the government, providing a further boost to your savings. The amount of tax relief you get will depend on what rate of tax you pay.

Compounding only works if you leave your money untouched, and the effects are noticeable if you invest over a long period of time. To find out more about the case for buying and holding investments, read our article here.

Risk notice

Any information provided should not be considered personal advice. Past performance is not a guide to future performance. You may not get back the full amount you invest. If you have any doubts about making your own investment decisions, seek financial advice. Tax treatment depends on individual circumstances and may be subject to change in the future. The information given is not intended to provide legal, tax or financial advice.

Compare accounts

  • Choose your own investments – pick your own stocks and shares to meet your investment needs, or choose from our Select List of highly rated funds.
  • Ready-made investments – if you want a simpler option, you can choose between our three diversified funds: low, medium or high risk.

Investment Trust Centre

Find an Investment Trust that works for you from our large selection of over 200.

Important legal information

The Lloyds Bank Direct Investments Service is operated by Halifax Share Dealing Limited. Registered Office: Trinity Road, Halifax, West Yorkshire, HX1 2RG. Registered in England and Wales no. 3195646. Halifax Share Dealing Limited is authorised and regulated by the Financial Conduct Authority, 12 Endeavour Square, London, E20 1JN under registration number 183332. A Member of the London Stock Exchange and an HM Revenue & Customs Approved ISA Manager.

Logo Web Financial Group

The information published on this website is accurate to the best of our knowledge. However, we do not assume any liability whatsoever for the accuracy and completeness of the information and any reliance you place on such information is at your own risk.

The information contained within this website is provided by Web Financial Group, a parent company of Digital Look, unless otherwise stated. The information is not intended to be advice or a recommendation to buy, sell or hold any of the shares, companies or investment vehicles mentioned, nor is it information meant to be a research recommendation.

This is a solution powered by Digital Look Ltd incorporating their prices, data, news, charts, fundamentals and investor tools on this site. Terms and Conditions Prices and trades are provided by Web Financial Group and are delayed by at least 15 minutes.

Logo Morning Star

The investments' operational and portfolio data on this website is sourced by Morningstar and is believed to be correct, but cannot be guaranteed. You should check any information you rely upon to make an investment decision to ensure that it is accurate and up to date. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Any views and opinions made by Morningstar do not represent those of Lloyds Bank.