Compound Interest Explained: Investments

Compound Interest Explained: Investments
Sharm El Sheikh Egypt by Julian Cohen. Why?

Einstein is credited with saying that compound interest is the eighth wonder of the world, and I, for one, agree with him.

(First published 12 December 2012)

In the last week, I’ve received adverts from three different companies promoting investments. The adverts were beautifully put together.  And the rates I could expect to receive on my money seemed very attractive. 

I showed them to a few people, and asked them to rank the adverts in order, putting the one they thought offered the highest return at the top, and the one that offered the lowest return at the bottom. 

Here’s the result:

Investment 1

Return on Investment (ROI) of 255 per cent

Investment 2

Annualised Return of 15.11 per cent

Investment 3

Year 1: 12 per cent, Year 2: 13 per cent, Year 3: 14 per cent, Year 4: 15 per cent, Year 5: 15 per cent

So how did they do?

As each of these three adverts displays the return using a different method of calculation, the only way to arrange them in the correct order is to compare them on a like-for-like basis. 

And for that, you need to work out how much they each earn on a compound interest basis. 

Let’s Take A Closer Look

Investment 1

It boasted that £21,000 could return £74,734 at an ROI of 255 per cent.  Hidden away in the very small print at the bottom of the email, lost among lots of other words, and presented in a tricky to read grey font on a slightly lighter grey background was quoted a 12 year term.  That’s what I was searching for.

On a compound interest basis, it's 11.16 per cent per year

Investment 2

For an investment of £52,084, it suggested I could receive a profit of £39,336.44 five years later, which it said was an ROI of 75.53 per cent.  They’d divided the ROI by the 5 years the investment would run, to arrive at an annualised return 15.11 per cent.

On a compound interest basis, it's 11.91 per cent per year

Investment 3

I was shown figures for a £100,000 investment.  The table revealed what my money would be worth at the end of each year: £112,000 (once 12 per cent had been earned); £126,560.00 (with 13 per cent added); £144,278.40 (with 14 per cent added); £165,920.16 (with 15 per cent added); £190,808.18 (with 15 per cent added).

On a compound interest basis, it's 13.79 per cent per year

So what can we learn by all this?

Don’t Be Fooled By Big Numbers

The Oxford English Dictionary defines marketing as “the action or business of promoting and selling products or services”.

When you’re selling something, you’re obviously going to give it your best shot.  And when it comes to investments, that means talking about great returns.  I have no problem with that. 

But before you part with your hard earned cash, always work out the compound interest rate.  And that'll enable you to properly compare what you’re being offered with other opportunities.

In many ways, the promoters of Investment 1 have missed a trick. 

If they’d used the method of calculation adopted in Investment 2, they’d have divided their ROI of 255 per cent by the 12 year term, and arrived at an annualised return of 21.25 per cent. Now that is a big number.  Mind you, it's arguably too big a number, for we're all rather wary of investments that appear to be 'too good to be true'.

But it doesn’t change the fact that it’s still the lowest earning investment of the three!

Never Invest On The Figures Alone

Nothing in life is guaranteed, except perhaps the first £75,000 invested in a building society. 

Things go wrong, and that includes some of the safest, regulated investments.  The stockmarket is littered with many high profile failures of long-standing, big and apparently strong companies going bust.

So it’s vital you always assess the level of risk in the investment you’re considering and ensure it matches your own view of risk at the time you part with your money.

As for the above investments, it might surprise you to learn that Investment 1 has the highest risk profile and Investment 3 has the lowest.  So potentially, you could lose twice if you invest in the order listed in the first table above.

Investment 3 Is The Compound Interest Winner But No-One Spotted It

It highlights the importance of understanding compound interest and comparing investment returns on a like-for-like basis.

Check out our featured Investments.

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