By now you have probably heard about the magical land of compound interest where Warren Buffett is king and money grows on trees.
And you probably also know that stocks don’t pay interest. So how does the magic of compounding work when it comes to stocks?
It works by continually making profits from the stocks you invest in, compounding the returns.
Further down we’ll go over the two ways you profit from stocks and also look at some examples.
But first, for those of you who don’t know how compounding interest works, let’s begin with an example (if you already know, you can skip this part):
Imagine having $10,000 invested in something that pays you a 10% interest every year. In the first year, you’ll receive $1,000 in interest.
If you then reinvest the $1,000, you will have $11,000 to earn a 10% interest on. So the second year you earn $1,100 in interest.
In the third year, repeating the process, you earn 10% on $12,100, an interest of $1,210.
This is a snowballing effect where you’re basically earning interest on your interest. Had you not continually reinvested the interest you received, you would have continued to earn $1,000 in interest each year.
The difference between compounding and simple interest gets bigger and bigger over time.
Continuing with the example above, if all the interest is reinvested, the original $10,000 will be worth $67,000 after twenty years.
Without compounding interest, it would be worth $30,000.
So now that we know how compounding interest works, let’s look at how the same effect works with stocks.
Compounding Stock Returns
First off, since stocks don’t pay interest, let’s call it compounding returns instead.
Secondly, stocks are usually considered much riskier in the short-term than something like a savings account, mostly because of their price fluctuations. In the long run, though, the stock market has proved to be the best way to invest, historically.
But unlike a savings account or government treasury bonds, there are no guarantees when it comes to stocks. You’re not promised any profits and some years you will even take losses instead.
Historically speaking though, the stock market as a whole has returned an average of 10% per year. Now you could do better or worse than that, depending on your strategy.
If you’re not really into investing and don’t know how to pick stocks, you should probably go with an index fund to get the best compounding returns. Here is an article helping you decide between picking index funds or individual stocks as a strategy.
Since stocks don’t pay interest, it’s your potential profits from investing in stocks that will have the compounding effect, if done right. There are basically two ways you can make a profit from stocks:
- You sell a stock at a higher price than what you bought it for.
- You collect dividends from the stock.
I’ll explain both below.
Buy Low, Sell High
So one of the ways you can make money from stocks is by buying at one price and then selling at a higher one.
For example, let’s say you bought shares of a fictional company named Bongo back in 2015. One share cost you $100 back then and you bought 10 of them for a total value of $1000.
- In 2016, the share price increased 15% to $115. Your shares are now worth $1150.
- In 2017, the share price increased by 10% to $126.5. You now have $1265 worth of shares.
For some reason, you don’t believe in the company anymore and decide to sell your shares and invest the money in a company named Bongo Bongo instead.
Bongo Bongo’s shares cost $253, so you invest your $1265 to get 5 shares.
- In 2018, Bongo Bongo’s share price increases 20% to $303, making your shares worth $1515.
- In 2019, the price increased by 10% to $333, making your shares worth $1665.
- And in 2020 they increased 15% to $383, for a total worth of $1915.
As you can see, it works the same as interest on interest but in this case, you’re getting returns on your returns. A 15% return in 2015 made you $115 and a 15% return in 2020 made you $250.
Now, if you had taken the profit each year and spent on something else, instead of letting it stay invested you would have made $665 instead of $915 in profits over the five years.
This effect only gets bigger and bigger as time goes by. Let me show you with an example:
Averaging the returns of the five-year period in the example and compounding them over 20 years, $1000 would have turned into $13,433. Without compounding, the original $1000 would only be worth $3,774.
That’s a difference of $9,659 you get by just leaving the money alone to work for you. And this is just an example of a one-time investment of $1000. Imagine if you had also invested monthly during the period.
What causes stock prices to increase or decline?
Now that we have established that compounding returns can be the effect of continually increasing stock prices. You might wonder what causes stock prices to increase or decline.
We’ll have a quick look at that before moving on to the second way compounding works when it comes to stocks.
There are many things that effect stock prices but the most common is an increase or decrease in the company’s profits.
An increase in profits can be the result of growth or because the company is successfully cutting costs.
A decrease can happen because of things like more competition or an increase in material or production cost.
Another reason for an increase or decline in price is because the stock was over- or undervalued in the first place.
Value investing is an investment strategy that focuses on finding and buying undervalued stocks.
With a general overview of one way compounding works for stocks, let’s move on to the second way.
Another way to earn money through stocks is to receive dividends. When companies earn a profit, they can decide to distribute it to the shareholders. This is known as a dividend.
It’s common for a mature company to distribute dividends. Especially when all of its profits are no longer needed to expand the business. Any amount not distributed is then reinvested.
Instead of paying dividends, some companies retain all their earnings in the hope of growing their profits. If successful, this will result in higher share prices so that the investors can profit even if they did not receive any dividends.
Compounding dividends works almost exactly as compounding interest. The dividend, in this case, is the interest. To compound dividends, you must continually reinvest them in dividend-paying companies.
Let’s say you buy twenty shares worth $100 each for a total of $2000. The company you invested in pays a $5 dividend per share.
The first year you receive $100 in dividends, enough to buy another share. In year two, you receive dividends on all your shares, including the one you bought.
Imagine repeating the process over many years, continually reinvesting all dividends. Many companies steadily increase their dividends each year, furthering fueling the compounding effect.
It’s important to note that you don’t have to reinvest your received dividends in the same company. You don’t even have to reinvest them in a dividend-paying company.
You can mix both the ways you earn money from stocks, it’s all up to you. The dividends you receive can be reinvested in a company that pays no dividend but that you think will grow at a rapid pace.
If you’re not comfortable with picking stocks, I suggested index funds before. Most index funds actually pay dividends. If you want to know more, you can read this article.
In the world of compounding returns, time is your best friend. It may take some time to get the snowball rolling, but when it starts rolling it takes everything with it.
And if time is your friend, losses are your enemy. It’s pretty self-explanatory that compounding will not work if you’re continually losing money. So if you want to compound your returns, maybe don’t invest in some obscure pharma stock some guy at work recommended.
Even if losses are your enemy, you should be careful with low-return investments. Savings account are good for placing the money you know you will need in a not too distant future. But for long-term investments, they will pretty much guarantee you a loss.
The reason is inflation. According to statista.com, the average inflation rate in the U.S. over the last 20 years is 2.2% annually.
So while you might think saving your money in some account paying you 0.6% interest is safe, in the long run, it really isn’t.
In twenty years, with a yearly interest of 0.6% and inflation of 2.2%, $100,000 will turn to $72,500. A loss of $27,500 for playing it safe.
That’s it! Thank you for reading and good luck with the compounding.