Albert Einstein reportedly described compounding as the eighth wonder of the world. While compounding can’t really compete with the Great Pyramid of Giza, it can do wonders when it comes to growing your money over the long term. 

Further on in this article, we’ll show how maximising your individual savings account (ISA) allowance every year for 20 years could potentially produce a pot worth over £660,000, with two-fifths of that coming from compounded investment returns. 

Of course, not everyone is able to invest £20,000 a year. But the beauty of compounding is that even relatively small amounts can balloon into sizeable sums over time.

Read on to find out how compounding works and what it could do for your investments.

What is compounding?

Compounding is when you earn returns on the money you invest as well as on the returns themselves. It is a relatively simple concept, but it can have a significant impact on your future wealth.

The table below shows a simple example of compounding in action. It assumes an initial investment of £1,000, which grows by 5% a year (excluding fees). You can see the increase getting steeper each year, as the 5% return is on bigger and bigger total amounts.

Compounding in action

So long as the money remains invested and any income is reinvested (as opposed to being drawn as cash), this process will go on and on, with the money growing by progressively larger amounts over time. 

How could compounding boost your ISA?

Compounding can be even more powerful if you keep adding to your initial investment. For example, if you were able to top up your ISA every year, you could build up a significant pot of money for your future.  

Let’s imagine you invest £20,000 (the current ISA allowance¹) every year for the next two decades and your money grows by 5% a year before fees. You would end up with a portfolio worth £661,319. Of that, just over £260,000 would have come from compounded investment returns. 

Even if you invest half the amount, you could still be sitting on a pot worth £330,660, of which around £130,000 would be compounded investment returns.

In the chart below, you can see the returns ballooning over time. The line gets steeper and steeper as compounding works its magic. 

The power of compounding your ISA allowance

Notes: This hypothetical scenario is for illustrative purposes only and doesn’t represent a particular investment or its expected returns. It assumes annual returns of 5%. Balances reflect the value at the end of each period. The chart doesn’t account for taxes and management or platform fees.

Bear in mind that these are all hypothetical examples. In real life, investments can go down as well as up and you may get back less than you invest. Market performance will therefore be a key factor in determining how fast your money really grows. 

Beware the impact of fees

Another factor that will affect how fast your money grows is fees. Just like investment returns, costs compound over time. So, while an extra percent might not seem like a lot, over time it can really add up and eat into your returns. 

Let’s imagine in the above example that you pay annual fees of 0.5% for your ISA and underlying investments. In the case of the £20,000 annual investment, your pot at the end of the 20-year period would be worth £627,429. But if you paid annual fees of 2%, your pot would be worth just £537,408 – that’s £90,000 less. 

While you can’t control markets, you can control the costs you pay. By minimising costs early on – perhaps by investing through a low-cost Vanguard ISA – you could reap the rewards later.

¹ Source: Gov.uk