Please refer to the glossary for an explanation of the investment terms used throughout this article.
Major reforms have transformed pensions, making them much less restrictive, and personal tax-free allowances have been introduced for dividend and savings income. For long-term investors, though, ISAs have lost none of their shine. The wrappers are not only flexible — they can hold cash savings as well as investments in stocks and shares, and recently to peer-to-peer loans — but all income and capital gains, however great, are free from personal taxation.
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With interest rates on cash ISAs languishing near historic lows, there is limited incentive for cash savers to rush in much before the tax year end. For those investing in stocks and shares, however, the case for squirrelling money into their tax-efficient wrapper early in the year remains as strong as ever. Although as always, please remember that the value of investments, and the income from them, will fluctuate.
This will cause the fund price to fall as well as rise and you may not get back the original amount you invested. The simple reason is compounding. The sooner money is invested the longer it can work to deliver returns. Why is that? It can result in the potential for ridiculously more money over longer and longer periods of time.
Option A is easy to understand.
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This is due to the losses from inflation over that time. This of course never really happens in reality but it will help show how compound interest works in this lesson. Now continue this process for 3 more years and we come to the end of Year 5. Notice how as our total portfolio amount increases, so does our return on that investment. Now fast forward to the end of 20 years. Now the amount of money we earn from our total investment red actually starts to surpass the total amount of money we initially invested each year blue. By the end of Year 40, the power of continuous compound interest has resulted in the returns actually contributing more into the total portfolio way beyond what we originally put into it.
Which option would you have rather gone with? Every successful investor, from Warren Buffett to Peter Lynch to John Bogle, all rely heavily on the power of compound interest. This is why smart financial planners almost always recommend starting your retirement savings early and investing as much as you can afford.
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Note that it does matter how you invest. Nearly all investing involves some level of risk. However, they stay away from riskier investment options like day trading, where very few investors make money.
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Use their successes — and failures — to get more information to help you make investment decisions that work for you. The powerful results of continuously compounded interest and returns can help you increase your portfolio by a great deal more than you would be able to without it.
An essential part of discovering the best passive income sources for yourself is seriously considering the power of compound interest.