Albert Einstein is often cited as having described compounding as the ‘eighth wonder of the world’.

Whether he really did say this is another matter.

It’s fair to say, nonetheless, that compounding is an awesome friend to have as an investor, and the more time you give it and you can shelter your investments from tax and reduce your costs, the more powerful it becomes.

It’s why investing regularly as a young adult in a tax-efficient and low-cost individual savings account (ISA) and/or self-invested personal pension (SIPP) not only boosts your chances of long-term investment success but also encourages you to aim higher.

In one’s compound interests

But, first, what is compounding? Simply put, it’s a mathematical phenomenon that captures how investment returns can build on themselves as they are reinvested, year after year, potentially adding to the value of your investments. In this way, you’re not just earning a return on what you pay in, you’re potentially earning a return on what you previously earned too.

To illustrate that, imagine you had put away £100 a year for 10 years and earned a total return on that money of, say, 5%. You would end up with £1,050. But what if you had earned 5% a year on it? In this case, we calculate that you would end up with almost £1,258 – so £1,000 of capital paid in plus an extra £258 on top.

And it’s just the start, potentially, because if you were to continue investing at the same rate and earn the same annual return, only £2,700 of the eventual £5,467 pot you would have after 27 years would be what you had paid in.

In other words, you would have more than doubled your money thanks to the power of compounding.

Markets, of course, don’t move in straight lines. So, the value of your investments and the returns they produce can fall as well as rise; you could get a better average annual return, or you could get a worse one. But you get the gist, hopefully, about how compounding can potentially work in your favour.

You’re only young once

It’s why younger investors have a potential advantage over older investors. Because time is on your side. As such, you have a greater opportunity to harness the power of compounding to build up sizeable nest eggs.

It doesn’t matter how little you start with (at Vanguard, you can open an account with £100 per month). What matters is that you start sooner rather than later, so that your money works as hard for you from the get-go as it possibly can.

You can then increase your contributions, should you choose, as your career evolves and circumstances allow. In this way, you develop good financial habits that last you a lifetime and are better equipped to ride out the inevitable ups and downs of markets – by leaving your money invested, guided by Vanguard’s four principles.

Why costs matter

Which brings me back to your investment costs and taxes, and why minimising them both is so important to your investment success.

Let’s imagine a 5% average annual return, as in my earlier example, but with costs factored in. I’ve assumed two different investment scenarios – a high cost one and a low cost one.

At Vanguard we charge an annual 0.15% platform fee, while our ongoing funds charge (OCF) across more than 80 funds1 averages out at around 0.2%. If we round up the total to 0.4%, to keep things simple and take into account transaction costs2, this makes for a hypothetical net return after costs of 4.6%.

Now imagine a second scenario in which an investor’s total costs are 1.5% a year. How much difference would this make?

The answer is quite a lot, as illustrated by the chart below, which shows how a direct debit of £100 a month, incrementally increased each year by 5%, would grow over time under each hypothetical scenario.

After 40 years, the lower-cost investor would have almost £60,000 more after 40 years – a performance gap that would only be bigger if even more was invested each month or more time was allowed.

Mind the gap: The impact of costs

Source: Vanguard calculations

Why taxes matter

It’s a similar story with taxes, which are also a cost that can reduce your returns by taking a bite out of the income you may receive or profits you may make.

It’s why it is important to shelter your investments from tax by investing through an individual savings account (ISA) or – if you don’t need to access the money before retirement – through a pension.

All UK residents aged 18 or over can invest up to £20,000 per tax year in an ISA. That means you have until midnight on 5 April to make the most of the 2022/23 allowance before it elapses.

For more on the differences that investing tax efficiently through an ISA rather than with a general account can make to your wealth, see this article.

¹ In reality, the OCF could be slightly lower or higher, depending on the Vanguard funds you choose. In the case of our LifeStrategy range of multi-asset funds and our FTSE All-World UCITS ETF, for example, it’s 0.22%. Our FTSE 100 Index Unit Trust, on the other hand, has an OCF of just 0.06%. The cost of each our funds is spelt on our product pages.

² Including dealing costs if you invest in, specifically, exchange traded funds (ETFs) and wish to trade in real-time (rather than accept the next available price).