8 min read

What Einstein could do for your baby’s savings

Steve Ferrari, Managing Director of Children’s Savings at OneFamily, talks us through how compound returns could help your baby’s savings grow into a nest egg over the years.

“Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.” Albert Einstein

What is compound interest?

Compound interest is interest earned on top of interest. The interest made from an initial deposit is added to the value of the account instead of being paid out. Further down the line, interest is then earned on that initial deposit as well as the previously accumulated interest. And so on.

Compound returns are the same concept but applied to investment products. You can earn returns on your initial investment, and you can generate further returns on the total. This process continues year on year with your investment (hopefully) growing in the long term. Of course, as with all stocks and shares products, your investment is at the whim of the market. This means it’s possible to get back less than you put in.

With a one-month old baby your mind’s full of more pressing matters. Such as trying to stay awake during the day and whether a seventeenth call to your GP is excessive. But it’s never too soon to prepare for your little ones’ financial future. And this is where we can learn a lot from Albert Einstein and compound returns.

How can compound returns work for your baby’s savings?

With the rise in university tuition fees, the inflated property market and the general cost of living, the earlier you can start preparing for your baby’s future, the better. Any veteran parent will tell you that they go from nappies to nights out in the blink of an eye.

But if you start saving early, do so little and often. Over the long-term, you’ll be amazed how much the money could build up over time. Of course, you have to put it into an account or an investment that works for you, your individual circumstances and your financial goals. So for example, if you’re saving into a cash product you could be getting sub 1% returns a year after deducting 2.4% for inflation*. In this case compounding may not work particularly well. This is because you could be starting from a very low annual rate of return. Cash is a safer option, certainly, however it doesn’t make your money work very hard for you over the long-term.

If you start saving into an investment product, where your provider will invest your money in the stock market, the returns are potentially better. Admittedly the stock market is more volatile, which means you could lose more than you put in. But over the long-term the UK stock market, according to research by Barclays and Courtiers, has returned an average of about 5% each year since 1900**. Unfortunately of course, past performance isn’t a guarantee of future performance.

Even when taking into consideration the rate of inflation, that sort of return could help your baby’s savings grow a lot more over the course of 18 years. If you saved £20 a month for 18 years, you’ll have paid in £4,320. If this was in a stocks and shares product with compound returns at 5%, the total would be approximately £7,747. Compare this to a cash product with 1% return per annum, and you’d be looking at about £4,731***. This is just an example of course, but it demonstrates how your baby’s savings could grow.

How could time in the market mitigate risk?

Now of course, there’ll be some years where there are falls in the stock market. But conversely, there will be years when it’ll go up more than average too. Again, if you start saving as soon as your little one arrives, especially if you choose a tax-efficient account like a Junior ISA, then you’ve got 18 years for your investment to weather the market fluctuations it is likely to experience.

Stocks and shares should really be seen as a long-term investment option of five years or more. It’s very difficult to time the market – if I could do that I’d be a billionaire – but the stock market could be an effective long-term home for your baby’s savings as they won’t get their little hands on it till they turn 18. So you’ve got all this time for the compound returns to build on your investment.

Due to market fluctuations your investment will probably go up and down in value, so depending when you take it out, you could get back less than you invested. But this is the crucial point – time in the market.

Even when their Junior ISA matures, there are a number of options for your child’s money. They may want to open an adult ISA and continue saving tax efficiently. Remember though, tax treatment depends on individual circumstances and may be subject to change in the future. Or, if one of their goals is to get on the property ladder, they might want to consider a Lifetime ISA.

How else could you manage the risk?

In an ideal world you would have a small amount of cash savings for those emergencies – when the boiler breaks, or the family car needs repairing. Then you can get hold of some money in a hurry, without moving it from your long-term investments. This isn’t viable for every household, so it’s important to only ever save what you feel comfortable with.

There are a range of fund types, some more risky than others. If you do choose to invest in stocks and shares rather than cash then it’s important you select the product and investment options that are right for you and your family’s financial situation. When it comes to your baby’s savings, the Junior ISA can also be split between cash and stocks and shares products. So if you want to spread the risk, the option of both savings and investments is there. And if you’re ever in doubt, seek the guidance of a financial adviser.

When it comes to your baby’s savings, 18 years might feel like a long time, but getting into the savings habit as soon as they’re born, should help pay off when they become a young adult.

Einstein’s not going to get up for that 3am feeding but through compounding he might help you send them off to university, put a deposit down for a house or start up that revolutionary new app.

Written by Steve Ferrari – Managing Director of Children’s Savings at OneFamily

 

*Sources: Inflation and price indices as of August 2018 from ONS.Gov

**Equities vs Gilts: 118 Years of UK Market Data

***These are examples and should not be taken as fact. They do not take factor in the likes of fees and management charges.

Note: Whilst we take care to ensure Talking Finance content is accurate at the time of publication, individual circumstances can differ so please don’t rely on it when making financial decisions. The opinions expressed within this blog are those of the author and not necessarily of OneFamily.

 

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