This quirk of maths can turbocharge your investment returns

Whether you prefer to invest in active funds, shares or simply passively “buy the market”, there’s one thing that you shouldn’t underestimate: the power of compound interest, achieved through investing for the long term.

Albert Einstein allegedly described compounding as “the greatest force in the universe” and apparently mused that “he who earns it, understands it; he who doesn’t, pays it”. 

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While the debate will no doubt rumble on regarding the authenticity of the quotes, as far as investors are concerned, the power of compound interest is not up for debate.

In a nutshell, compound interest refers to the way investment returns themselves generate gains. For instance, if you invest £1,000 into a fund returning 5% over one year, you'll earn £50. Assuming 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 effect becomes even more powerful when compounding takes place alongside the reinvestment of dividends. Over the long term, dividend growth is where most of the stock market’s returns come from. 

One key takeaway for beginner investors looking to improve their odds of stock market success is to invest for the long term and reinvest both capital gains and income. Those who do will reap the rewards of compounding.

Another lesson is to invest as early as possible. Our own research hammers this point home. Someone investing £250 per month into an investment returning 5% a year would experience an investment gain of £83 on £3,000 total contributions. This investment growth accounts for just under 3% in year one, rising to over 5% in year two and almost 14% by year five.

By year 10, investment growth would make up 30% of the portfolio, and 72% by year 20. The investment tipping point happens at year 26, when investment growth accounts for 105%, turning £78,000 worth of monthly contributions over the period into £160,229.

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Investment trusts are a particularly attractive vehicle for anyone seeking a reliable and rising income. This is owing to their ability to hold back up to 15% of the income they receive each year in a revenue reserve. This gives them an advantage in delivering income to investors during lean periods.

This structure demonstrated its advantage during the global financial crisis and the Covid-19 pandemic. Boards dipped into their reserves to top up income shortfalls from underlying investments so that they could maintain their long track records of raising the dividend year in, year out.

There are 18 “dividend hero” investment trusts that have increased their dividends for more than 20 years. Waiting in the wings for dividend hero status are 27 trusts that have increased dividends for 10 or more consecutive years, but fewer than 20.

In many cases, the dividend heroes and next-generation dividend heroes are excellent options for investors. Moreover, for many investors, particularly those in retirement, the consistency of a rising dividend is something to treasure.