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Why compound interest is important

Many of us are building a pension fund, a portfolio of shares or deposits with our bank or building society.

Most of these investment options reward us for our participation by offering income (usually in the form of interest or dividends) or by demonstrating capital growth (share prices increasing).

Accordingly, there are three components to our investments: the capital sum we invest, any growth in the value of the capital sum invested or rewards (interest or dividends) paid by banks or companies in which we hold shares.

What we do with these rewards, particularly interest and dividends, is key to the speed with which our investments grow.

The reason for this is the impact of compound interest.

If the average return on your investments is say 3%, paid as dividends or interest, if you withdraw these payments your investments will maintain their capital value and over time inflation may reduce the purchasing power of this capital value as the value of money decreases.

Whereas, if you reinvest rewards, future returns will compound, and you are more likely to counter the effects of inflation.

Over short term periods these effects are small, but over longer periods the impact of compounding can be dramatic.

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