Ask ii: what is compound interest and how do investment fees affect it?

No question is a stupid one, so whether you want to find out what you need to do to start investing or how the stock market works, don’t be shy, ask ii. Email yours to: ask@ii.co.uk

Mr Mackie asks:I have an ex-employer pension and pay nearly £3,000 in annual management charges on two funds. One tracks a technology stocks index and one is an underperforming active fund with high charges. How are the high fees negatively affecting the compounding interest generated by my funds?

Sam Benstead, deputy collectives editor, interactive investor, (pictured) says: Compound interest: he who understands it, earns it… he who doesn’t, pays it. Or so Albert Einstein apparently said.

Whoever made those famous comments was spot on: compound interest is the single most important thing to understand about successful investing.

Put simply, it refers to the reinvestment of interest back into an initial pot of money. This allows for investment returns to snowball over time, leading to extraordinary gains for investors who are diligent enough to keep reinvesting dividends and adding to portfolios, while also having the patience to allow returns to compound.

Let’s look at the numbers. If you invest £1,000 into a fund returning 5% over one year, you'll earn £50. Assuming that you don't withdraw any money, the next year you'll earn 5% on £1,050, which is £52.50.

This doesn't sound like much of an uplift, but as each year passes, the compounding effect multiplies. The £1,000 investment left to compound for 30 years at a 5% yearly return would turn into £4,321, or more than £3,000 in “free” money after the £1,000 investment.

• 60 reasons to sell your UK shares
• Expert investment tips from £50 to £50,000
• Discover our Don't be shy, ask ii questions here
• Don’t be shy, ask ii…which low-cost ETFs should I put in my pension?

Applied to an investment case study, someone making 8% a year over 30 years and investing £200 a month would end up with nearly £300,000 after putting away just £72,000 of their own money.

Even if they stopped adding money to their portfolio after 10 years and then waited for the final 20 years, the pot would still grow to £180,000.

There are two parts to the equation: interest rate and time invested. Investment fees eat into the interest rate that investments compound at. 

If investment fees were 1% higher, equating to a 7% rather than 8% annual return, then our investor would retire with just under £60,000 less after contributing for 30 years.

Without knowing the percentage fee that Mr Mackie is paying on his portfolio, it is impossible to know how much better off he could be. But we can say for certain that paying less for the same investment return will definitely increase his returns. Keeping fees low is one of the few things that investors can control and should be a priority for savvy investors.