Interactive Investor

ISA season: ‘compound interest is a powerful ally to investors’

Our calculations highlight the power of compound interest over the long term, with the ‘investment tipping’ point achieved after 26 years of contributions.

30th January 2024 10:53

Myron Jobson from interactive investor

  • Investment growth surpasses monthly contributions at year 26, assuming a 5% annual investment return, or at 18 years assuming 7%
  • Compounding returns offer a layer of protection against investment volatility
  • Myron Jobson outlines eight tips for ISA season below

The ISA season is upon us – typically kicking off in February and running through to the beginning of April. Following a turbulent start to the year for markets, many investors will be wondering how best to position their portfolio.

New calculations by interactive investor, the UK's second-largest investment platform for private clients, illustrate the benefits of keeping calm and carrying on, with compounding returns providing some protection against short-term investment volatility.

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.

The effects of compounding interest over 30 years on £250 monthly contributions, assuming 5% investment return

Year

Total contribution

Investment growth

Total portfolio value

1

£3,000

£83

£3,083

5

£15,000

£2,072

£17,072

10

£30,000

£8,982

£38,982

20

£60,000

£43,187

£103,187

26

£78,000

£82,229

£160,229

30

£90,000

£118,932

£208,932

Source: interactive investor

Assuming an annual investment return of 7%, it would take 18 years to reach the investment tipping point, with investment growth accounting for just under 4% in year one, rising to 20% at five years and 45% at year 10.

It is the same story for lower monthly contributions.

The effects of compounding interest over 30 years on £250 monthly contributions, assuming 7% investment return

Year

Total contribution

Investment growth

Total portfolio value

1

£3,000

£116

£3,116

5

£15,000

£3,003

£18,003

10

£30,000

£13,524

£43,524

18

£54,000

£54,308

£108,308

20

£60,000

£70,991

£130,991

25

£75,000

£128,699

£203,699

30

£90,000

£216,772

£306,772

Source: interactive investor

Myron Jobson, Senior Personal Finance Analyst at interactive investor, says: “The key takeaway from our calculations is investors needn’t worry about what markets are doing on a day-to-day basis but remember that serious gains can be achieved over the long term.

“Compound interest is a powerful ally to investors, acting as a buffer against market volatility, turbocharging returns, and helping to smooth out the bumps and potentially the impact of market fluctuations on your overall returns.

“Generally, as your investment grows, compounding becomes more significant, and there’s a point where growth outpaces new contributions. This varies for each individual’s investment strategy and market conditions. In our scenario, the investment tipping point is 26 years, but the reality is many investors will hit their financial goal, be it investing to buy a home or for retirement, a lot sooner. Still, investment growth could be responsible for an increasing portion of the fund value over time. Time in the market, not timing the market, is the name of the game.

“The nature of investing means the annual rate of return isn’t fixed, meaning you can earn more or less in a given year, depending on the market environment. But compounding returns offer a layer of protection against investment volatility. So, investing as much and as early as you can – ensuring that all expenses can be met and maintaining a rainy-day fund – can pay dividends over the years. The key is to stay the course, don’t make unnecessary changes, and reinvest dividends and interest earned on investments.”

Myron Jobson outlines eight tips for the ISA season

1) Take advantage of the tax-free ISA wrapper

The shrinking capital gains and dividend tax allowances provide the impetus for investors to invest through a tax-efficient wrapper if they haven’t already done so. Shifting investments into an ISA protects future gains and dividends from the clutches of tax. Known as Bed & ISA, the process is a valuable tool as part of a broader portfolio spring-clean strategy. The transfer, however, will involve selling and buying back shares, which could trigger a capital gains tax bill.

Bed & ISA is a tried and tested route to wrapping existing investments to generate the long-term benefits of a tax-efficient ISA – which over the long term is likely to outweigh the charges that might apply.

2) Consider making use of your partner’s ISA allowance

You can also help reduce your taxable income by transferring assets between spouses/civil partners. Use both sets of ISA allowances: each year you can shelter £20,000 from tax in an ISA – so £40,000 between two. Couples can also effectively double gains and income they can make tax-free by using both their annual exempt amounts. Only married couples and civil partners can transfer assets tax-free, meaning those who aren’t could potentially trigger a tax liability.

3) Understand your risk profile

Risk is an inherent part of investing, but it’s a tough balance. Take too much risk, and you might find yourself racking up some painful investing lessons.

But taking too little (or no risk in the case of cash) is a risky strategy in itself. It could have a hugely detrimental effect on your finances in the future – because you might not reach your goals. And our risk appetite isn’t static; it can change as our circumstances change – so needs reviewing regularly.

4) Diversification

Diversification is the name of the game when it comes to investing. Spreading your eggs instead of having them in one basket reduces the risk of any one stock in the portfolio hurting the overall performance.

When it comes to diversification, that doesn’t just mean investing in different stocks. It also means having exposure to different sectors, assets, and regions.

5) Consider rebalancing

Portfolio rebalancing is akin to tuning an instrument, where every component plays a crucial role in achieving harmonious results. Trimming the excesses and redirecting funds into underperforming assets ensures that your risk-return equilibrium remains intact. This calculated approach of buying low and selling high has the potential to bolster long-term returns.

Rebalancing isn’t about timing the market, but about ensuring that your portfolio remains in sync with your long-term goals in the ever-evolving investment landscape. Whether nearing retirement or sprinting towards a shorter investment horizon, rebalancing grants the opportunity to recalibrate allocations to achieve the desired financial destination.

6) Costs and fees

Investors cannot control the market, but they can control how much they pay to invest. Understand the costs associated with your investments – not least the platform charge. Some great platform comparison sites are out there, and a good starting point is to think about your pot size. A flat-fee charging structure, in pounds and pence, can be far more competitive and means that as your assets grow, your charges stay the same. Over the long term, the differences can add up to thousands of pounds.

7) Drip feed your investments

A good and proven way of lowering your investment risk is by investing small amounts regularly. Most often, investors do this by drip-feeding investments monthly to help smooth out the inevitable bumps in the market. The advantage is that you also buy fewer shares when prices are high and more when prices are low – a process known as pound-cost averaging.

8) Set clear goals

Define your financial goals and time horizon before making investment decisions. Avoid making impulsive decisions based on short-term market fluctuations. Stick to your investment strategy.

Please remember, investment value can go up or down and you could get back less than you invest. If you’re in any doubt about the suitability of a stocks & shares ISA, you should seek independent financial advice. The tax treatment of this product depends on your individual circumstances and may change in future. If you are uncertain about the tax treatment of the product you should contact HMRC or seek independent tax advice.

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.