Albert Einstein reportedly called compounding the eighth wonder of the world. While it might not rival the Great Pyramid of Giza, compounding can do amazing things for your money over time. 

In this article, we’ll show how investing your individual savings account (ISA) allowance every year for 20 years could potentially grow your savings to over £660,000, with £260,000 of that coming from compounded 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.

What is compounding?

Compounding is when you earn returns on the money you invest as well as on the returns themselves. It’s a simple concept, but it can have a big impact on your 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. 

Compounding in action

Source: Vanguard calculations

Notice how the growth gets bigger each year? That’s because the 5% return is on bigger and bigger total amounts.

So long as you don’t withdraw your money, this process will go on and on, with the money growing by progressively larger amounts over time. The longer you leave your money invested, the more time it has to grow and benefit from the magic of compounding. 

How could compounding boost your ISA?

Compounding becomes even more powerful if you keep adding to your initial investment. 

Let’s imagine you invest £20,000 (the current ISA allowance) every year for 20 years and your money grows by 5% a year before fees. At the end of the 20 years, your portfolio would be worth £661,319. Of that, just over £260,000 would come from compounded returns. 

Even if you invest half the amount – £10,000 a year – you could still end up with a portfolio worth £330,660, with around £130,000 coming from compounded returns.

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

If you’re able to carry on investing £20,000 every year, your portfolio would reach £1 million after 26 years.

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% before fees. Balances reflect the value at the end of each period. 

Source: Vanguard calculations.

Of course, 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. But by staying invested, you give yourself a better chance to recover from any market dips and benefit from the snowball effect of compound growth.

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, which means they 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. A £20,000 annual investment would grow to £627,429 after 10 years. But if you pay annual fees of 2%, it would grow to just £537,408 – that’s £90,000 less. 

While you can’t control market performance, you can control the fees you pay. By choosing low-cost investments, you can keep more of your returns.

Investment risk information

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

Any projections should be regarded as hypothetical in nature and do not reflect or guarantee future results.

The eligibility to invest in either ISA or Junior ISA depends on individual circumstances and all tax rules may change in future.

Important information

Vanguard only gives information on products and services and does not give investment advice based on individual circumstances. If you have any questions related to your investment decision or the suitability or appropriateness for you of the product[s] described, please contact your financial adviser.

This is designed for use by, and is directed only at persons resident in the UK.

The information contained herein is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so. The information is general in nature and does not constitute legal, tax, or investment advice. Potential investors are urged to consult their professional advisers on the implications of making an investment in, holding or disposing of shares and /or units of, and the receipt of distribution from any investment.

Issued by Vanguard Asset Management Limited, which is authorised and regulated in the UK by the Financial Conduct Authority.

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