Why is compound interest so powerful?

Exchange for beginners - Part 2: The powerful compound interest effect - and its dangerous opponent

Many savers in Germany avoid the stock market out of fear. It doesn't have to be, because stock market transactions are not that complicated and offer the best return opportunities in times of zero interest rates. Karl Balz, an expert in the investor protection and investment company group of the European Securities and Markets Authority ESMA, has been investing on the stock exchange for 20 years and knows the errors and pitfalls. In his stock exchange 1x1 for private investors, he explains in an easy-to-understand way what savers need to know when taking their first steps on the stock market and which mistakes should be avoided. Its investor guide appears in eight parts on wiwo.de - and is also available here in full as a dossier for subscribers.

Time is the decisive factor when investing. This is mainly due to the compound interest effect. It stands for not only that your starting capital works for you and increases your assets by generating interest, dividends or price gains, but that the interest, dividends and price gains generated also work for you and in turn generate interest, dividends and price gains for you.

This in itself banal knowledge has an enormous impact on the development of your wealth. It is cited by many successful investors as the greatest eye opener when it comes to investing.

Let me illustrate this with a simple example.

Sample calculation of the compound interest effect

Assume that you have starting capital of 100 euros and that your investment generates an annual return of ten percent. This can be a bond that pays ten percent interest, a stock that pays a ten percent dividend every year, or a stock that rises ten percent every year. This does not play a role in the illustration of the compound interest effect. Nor that ten percent is a very impressive return that is difficult to achieve over a longer period of time. But ten can be calculated well. Finally, to make the compound interest effect clearer, taxes should be left out. I will come to that later.

The whole thing looks like this:

timeStarting amountAnnual yield in
Amount of 10% p.a
Year 1€100€10
year €110€11
year €121€12,10
year €133,10€13,31
year €146,41€14,64
year €161,05€16,11
year €177,16€17,72
year €194,88€19,49
year €214,37€21,44
year €235,81€23,58

First important finding: After ten years you will not have your starting capital of 100 euros plus 10x 10 euros (namely ten percent of the 100 euros every year) and thus a total of 200 euros, but 259.39 euros (235.81 euros + 23 , 58 euros). The difference of 59.39 euros is solely due to the fact that you have reinvested your annual income every year (the prerequisite is of course that this reinvested income also generates ten percent every year).

Second important finding: In the tenth year, you will already earn 23.58 euros, i.e. 23.58 percent, based on your starting capital!

Third important insight: Don't let the small amounts in the example mislead you. Just imagine that your starting capital would not have been 100 euros, but 100,000 euros. The 59,390 euros that are owed to compound interest (see above) sound better, right?

Fourth key takeaway: It's important to start investing early and keep reinvesting your income. This is the only way you can use the compound interest effect to build up your wealth. Your wealth grows exponentially due to the compound interest effect. The longer you are there, the better.

In other words: Perhaps the most important success factor when investing is the time you bring with you!

Fees, fees, charges - a reflection of the compound interest effect

For your investments, you need a bank that carries out your transactions for you, holds your securities for you, issues tax certificates, etc. If you buy a fund, it has to be managed, regulatory requirements have to be met and much more.

In short: You are dependent on the services of third parties (mostly banks) for your investments. And they take money for it. So life is. However, it is important to realize that the amount of costs and fees has a direct impact on your long-term investment success.

The compound interest principle also applies to costs and fees, just with a different sign. The amount that goes on from your starting capital or your income for costs and fees is not only gone, but irretrievably diminishes your wealth and cannot work for you. It is thus the reflection of compound interest. For this reason, even small fee differences over time make a big difference to your investment success. So be stingy.

For example, if you pay 1.5 percent fees for an investment fund (which is quite common for an actively managed equity fund like the one offered by your house bank), that may not seem earth-shattering at first. But do you realize that in this case, with a (realistic for an equity fund) return of six percent after ten years (more because of the compound interest effect), you will have spent more than a quarter of your income on costs and fees? In other words, that you would have made 25 percent more money if you had chosen a cheap ETF or index fund (on the terms later) with a fee of 0.1 percent? Of course, this assumes that the actively managed fund was unable to beat the ETF or index fund. More on that later.

The problem with costs and fees is that no bank, insurance, or other advisor will clearly point out the implications of the costs and fees. The consultants live from costs and fees. Your bank or your insurance agent or other investment advisor receives the entire issue surcharge for funds (usually five percent of your starting amount - you should never pay !!!) and then every year an inventory fee ("kick-backs") in the amount of Half of the management fee (i.e. for a fund with an management fee of 1.5 percent every year another 0.75 percent of the investment volume on top).

Many Germans shy away from stocks. But if you want to increase your wealth in the long term, you can hardly avoid it. Why fear of investing is unnecessary - and how it works, we show in our new series.

It is clear that your “advisor” or better seller will be weak and recommend an expensive fund and not a cheap ETF or index fund, even if he is not convinced that the more expensive fund will do better.

The bank has to say what fees you pay

In my opinion, the annual fees for your investments should not total more than 0.5 percent of your portfolio value (i.e. the value of all your investments combined). If you pay more, you are paying too much and should check whether your funds are too expensive or the transaction costs at your bank are too high. You shouldn't pay a deposit fee anyway.

But how do you see how much you are paying in terms of costs and fees? The legislature has helped you here. Since 2018, banks and other financial service providers have had to provide you with a so-called ex-post cost statement once a year. This includes both the total amount of all costs and fees and a breakdown of the individual items. You can quickly see from the total amount whether you are paying too much. You can use the breakdown to see why. It also shows you particularly expensive products, the exchange of which can further reduce the fees.

By the way, the information about how much your bank earns from you is particularly interesting. The ex-post statement of costs must also contain this information. In addition to the transaction commissions, custody fees (hopefully none!) And sales charges, you can see the inventory commission ("kick-backs") for each product that your bank receives annually for having brokered the product for you.

I find this information particularly interesting, on the one hand, because you can see how much you pay your bank for their service every year and you can get an idea of ​​whether you find the amount appropriate, and on the other hand, because it gives you a good impression of conveyed the motivation of your advisor.

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