How the magic of Compounding Could Help you Beat Inflation

By Alice Guy on June 25, 2022

Inflation is like a wolf prowling around your investments and savaging your hard won returns. But did you know that investors have a secret weapon at hand? Investment compounding is like a magic sword that can help you fight away the wolf and beat inflation. It can create astonishing inflation-beating returns and set you up to retire early.

How investment compounding works

Investment compounding is the eighth wonder of the world, according to Albert Einstein. It can help even ordinary investors achieve dazzling returns, defy expectations and beat inflation.

Investment compounding works like a snowball rolling down a hill.  It rolls faster and faster, picking up speed the further it rolls. Compounding helps your investments get bigger and bigger, the longer you keep investing.

If you reinvest your capital growth and dividend income, your wealth will build and build with every passing year. The extra growth accelerates over time, as growth and dividend income feed on your previous investing success.

This compounding effect has put rockets under Warren Buffet’s investment wealth and launched him into the wealthy super league. In fact, according to Insider, an amazing 99% of Warren Buffet’s wealth has been achieved after his 50th birthday.

That means, if he’d stopped investing at 50 and withdrawn his cash, he’d only have 1% of his current wealth. It’s the power of long term investment compounding that’s made the difference.

The chart below shows the investment return from  $10,000 invested in Warren Buffet’s company, Berkshire Hathaway back in 1965.

Insert infographic

What investing returns do I need to beat inflation?

In 2022, inflation is currently running red hot in the UK. The ongoing energy crisis and continuing supply chain problems are stoking the inflationary furnace to its hottest temperature for years. Inflation in the UK averaged 2.5% between 2021 between 1989 and 2021 and is estimated to reach at least 7% by the middle of 2022.

Investors need to find consistent returns of at least 3% to beat inflation. It’s bad news for cash investors, but is this possible with equity investing?

For equity investors, it’s not unrealistic to expect long term investing returns of 5% to 8%. Between 1957 and 2021, the S&P 500 enjoyed a stonking average return of around 10.5%. Long term investors can still expect to beat inflation, build up a comfortable nest egg and retire early.

Compounding case study: the surprising power of starting young

Let’s dive in and see how that compounding magic works in practice by looking at 2 investors: one starting early and the other starting later.

A tale of 2 investors

This astonishing case study shows how the stunning power of compounding can flip our assumptions on their head and catapult a modest investor’s investment wealth into the stratosphere. Compounding defies our expectations because it means that by starting investing young, you can end up with way more than you bargained for.

It’s crazy that Sam could end up with almost three times the investment pot of Julie, even though he invests the same amount. It’s all due to the astonishing power of compounding. The snowballing effect has had much longer to work its magic than for the older investor’s stock portfolio because he’s in the market for 40 years rather than 20 years.

3 tips to maximise compounding

If you too want to benefit from the magic of compounding and beat inflation you need to invest over as long a period as possible and target high returns. Here are some tips:

Start investing early to beat inflation

The earlier you start investing, the bigger impact compounding can have on your investment portfolio. It’s like taking that snowball to the top of Everest. The further it has to roll down, the more snow it can gather.

If you invested £10,000 and achieved returns of 7% it would be worth £40,387 after 20 years, £81,164 after 30 years, £163,114 after 40 years and a staggering £327,804 after 50 years.

Aim for high returns to beat inflation

Aiming for high returns will help you max out your investment compounding and beat inflation. And scoring that high return means seeking out a mixture of capital growth and dividend income.

If you want high capital growth then consider investing in smaller companies. Historically smaller companies tend to outperform larger blue chips in terms of investment growth. The FTSE Small Cap Index has increased 27.3% in the past 5 years up to March 2022, whereas the FTSE 100 has been virtually static and only increased 1.84%.

If you’re looking for dividend income then many blue chip companies have a dividend yield of at least 4%.  Stocks in global mining giant, Rio Tinto, have enjoyed price growth of 93.3% in the five years up to March 2022, and they also have a dividend yield of 10.1%. In contrast, stocks in UK housebuilder, Persimmon have only seen minimal share price growth of 1.2% in the five years up to March 2022. However they have a generous dividend yield of 10.6%.

Stick to your battle plan

In times of volatile markets, it’s easy to get distracted from your battle plan. There’s often a mass panic, and many investors end up buying high and selling low instead of buying low and selling high!

Sticking to the long term plan means carrying on investing regularly whatever is happening. You’ll end up buying when stocks are undervalued, overvalued and everything in between.

In fact, if you keep on investing when the stock market drops you could actually cash in later. In March 2009, the S&P 500 dropped to $683.38, down from a previous peak of $1525.75 in September 2008. It’s since climbed to $4,495.55 in March 2022. If you invested £10,000 back in 2009, it would now be worth around £65,812.

Conclusion

Investing is always risky and you could lose money as well as earning more. But the staggering magic of investment compounding can help you take a sword to inflation and win the investing battle.

Aiming for high capital growth, picking high dividend stocks and investing for the long term will all help you beat inflation into submission. The magic of compounding could be just what you need to achieve your dream and retire early.

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Alice Guy

Alice is a Suffolk-based personal finance writer and a qualified Chartered Accountant. She writes on topics including investment, pensions, tax and small businesses. She has previously worked for KPMG London and Tesco Plc.

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