Two amazing facts about finance

The third of our articles serialising ANDREW CRAIG’s book How to Own the World: A Plain English Guide to Thinking Globally and Investing Wisely covers the two simple, but amazing, facts about finance that we should all be aware of.

Andrew has worked in the City of London for over 20 years. In 2011, he founded plainenglishfinance.co.uk, a personal finance website that aims to help people to improve their finances.

I believe there are two amazing facts about finance to focus on immediately. Once you understand these, you should very quickly start to see the incredible possibility that effective investment offers you.

Fact 1: Compound interest is “the eighth wonder of the world”

One of the main objections I hear when I share with people my excitement about the wonderful world of investing is: “But that won’t work for me, I make too little to have enough left over to invest.”

Wrong! Wrong! Wrong!

Many people believe that they need a big lump sum or the ability to save a large amount of money every month to make investment worthwhile. People often believe that investment is “for the rich” and not for them. This is absolutely not true. With money, as with so many things in life, it is the tortoise who generally wins the race, not the hare.

Those who understand money and end up with lots of it tend to be those who understand that little and often is the road to success.

You are much more likely to save a small amount of money right now than you are to save a large amount of money at some time in the future. I’m sure you are familiar with this psychology – it is also true of going to the gym, revising for exams, doing housework, and so on. As you are about to see, time is one of your biggest allies in becoming wealthy, so you must take action now or as soon as possible. Start small but start now. If you do start small, no matter how small, you will enable yourself to benefit from the magic of compound interest immediately.

So, what is compound interest and why is it so important?

If you take nothing more away from this book than an understanding of the incredible power of compound interest, then you will have joined a lucky (and generally wealthy) few. None other than Albert Einstein described compound interest as ‘the eighth wonder of the world’. Compound interest is, quite literally, a form of free money … and it is free money that grows like a weed over time.

But how can this be?

Well, imagine that you invested £1,000 today. Imagine, too, that whatever you invested it in went up by 10 per cent this year. In this scenario, you would have £1,100 one year later: your original sum, plus £100 of interest, or return on a share or other investment. Simple so far. Now comes the ‘free money’ part. Assume you invested that £1,100 for another year and achieved 10 per cent again. The following year you would have £1,210. This time you have made £110 of interest (1.1 x £1,100 = £1,210), but £10 of that interest is essentially free money. It is the interest you have been paid on your interest – or, to put it another way, the return on your return. At first glance this may not seem particularly exciting, but over time the effect is incredibly powerful.

Fact 2: You have access to financial products and information sources that are better than ever before

One of the paradoxes of the last few years is that people have been so focused on the “global financial crisis” that they have generally missed some very interesting developments in the finance industry as a whole. It is only in the relatively recent past that the financial services industry has developed to the point that people from any background can invest in almost any asset class in almost any country and can do so easily, quickly, cheaply and, in the UK in particular, tax-efficiently too.

Let’s say you thought that the price of oil was going to increase. (Don’t worry for now about how you might have come to form this opinion.) Today you can own some oil with the click of a mouse, and with far lower fees than in the past. You can even make money betting that the price of oil will fall if that is what you believe will happen. Or perhaps you think that Brazilian farmland is going to increase in value, as the world’s population grows from 7 to 9 billion and Brazilian crops enjoy increasing demand. You can benefit financially from this belief from the comfort of your home.

Not that long ago, these sorts of investments were very difficult or even impossible to make. If you wanted to benefit from growth somewhere like India, China or Singapore or to make money from gold, oil or Brazilian farms, you needed a large amount of money, a relationship with a private banker somewhere like Switzerland, and a willingness to pay high fees and deal with lawyers. In the last few years, thanks to the Internet and intense innovation from financial services companies around the world, these hurdles have pretty much disappeared. As a result, investing is far simpler for us than it was for our parents or grandparents.

These days, if you have a basic grasp of what you are doing, you can easily and cheaply become the owner of almost anything. You have never been in a better position to make money out of a good idea than you are today. Sadly, very few people have any idea how to do this.

The reason for this is that the vast majority of people fall into one of three categories:

Those who do not invest any money at all

Those who do invest but use their high street bank for financial advice

Those who do invest but go to a substandard financial adviser.

There are now almost as many financial products available in the world as there are wine producers. Sadly, the main high street banks – and many IFAs – are like a wine merchant who sells a very limited range of mediocre wines at high prices.

There is a wonderful world of investment opportunity available out there if you know where to go. The key is choosing the right things to own, knowing how and where to buy them, and paying the right price for them.