The miracle of compound interest is the magical force that made Warren Buffett an incredibly wealthy man. Albert Einstein even called it “the eighth wonder of the world” and said, “He who understands it, earns it. He who doesn’t, pays it.“
Sounds sweet, but how does it actually work when it comes to ETFs? And do I need to do anything, or does it work by itself? These are some of the questions we will look at in this article.
In order to fully utilize the compounding effect, it’s essential you understand how compound interest works, generally, and how it works for ETFs.
So let’s start with the basics on how compound interest works. (If you already know, you can skip to the next part.)
How Compound Interest Works
Compound interest works by earning interest on your interest. Sounds confusing? Let’s look at an example to demystify it.
Imagine having $10,000 invested in something that pays a 5% interest every year. A 5% interest on $10,000 means you would earn $500 each year.
This next part is essential to get compounding interest working, without it, the whole thing falls apart.
To get the compounding effect, you take the $500 interest you earn the first year and reinvest it.
This means that you’ll earn 5% on $10,500 the second year, which adds up to $525 in earned interest. So, $500 is the interest on the originally invested $10,000. The $25 is from the interest on the previous year’s reinvested interest.
In other words, the $25 is interest on interest. It might not seem like much, it’s only 25 bucks, after all. But when compounding interest, time is your best friend.
The third year, with the $525 reinvested, you would have $11,025, and with a 5% interest, you would earn $551 in interest.
Let me fast forward twenty years, so you’ll understand how compounding ramps up.
In twenty years, $10,000 with a 5% interest rate will be worth $26,536, i.e., you earn $16,536 in interest. If you hadn’t reinvested the earned interest, your $500 each year would add up to $10,000 in earned interest over twenty years.
Both more time and higher interest dramatically change the compounding results. Imagine you earned a 10% interest each year instead.
$10,000 would turn into $61,000 in twenty years and $411,000 in forty. And remember, this is only with $10,000 invested a single time. Imagine if you had invested monthly, as well.
$10,000 at 10% interest and with $100 invested every month would turn into $1,036,000 in forty years.
So now that we know how compound interest works and how powerful it is, let’s move on to how it applies to ETFs.
How Do ETFs and Index Funds Compound?
So how do you get the compound effect working for you when it comes to ETFs? Index funds don’t pay interest, so how could they possibly compound interest?
First off, how you get the compounding effect with an ETF depends on what kind of ETF we’re talking about. The most common type of ETFs are equity (like index funds), and bond ETFs, so those are the two we’ll look at.
Let’s begin with bond ETFs.
How you Compound Bond ETFs
There are many different types of bond ETFs, which we won’t go over in this article.
Basically, a bond ETF contains numerous different bonds from which the ETF earns interest. The interest is then distributed as dividends to the ETF shareholders, often monthly.
You can probably see how you’ll get the compounding effect working already but let’s look at an example anyway to make it crystal clear.
Let’s assume you invest $10,000 in a bond ETF with a 4% annual dividend yield. This means you would earn roughly $400 in dividends (interest) annually or $33 monthly.
When you receive the dividend, you then reinvest it, as we talked about when we first looked at how compounding works.
What you reinvest the dividend in is up to you. You could reinvest it in the same ETF or another bond ETF, or a stock ETF, or individual stocks. You have the power of choice.
So, how compounding interest works with bond ETFs was pretty straightforward, right? But what about equity ETFs, like index funds, that don’t pay any interest, how do you compound them?
How ETFs, Index Funds, and Mutual Funds Compound Interest
First, let’s clear something up. Both ETFs and mutual funds can be index funds, the main thing that separates the two is how they are traded. (If you want to learn more about index funds, ETFs, and mutual funds, here is an article I wrote comparing them.)
Secondly, it doesn’t matter if it is an actively managed fund or an index fund, as long as the fund consists of stocks, the compounding effect I’ll explain works the same.
Equity ETFs, mutual funds, and index funds compound by continually increasing in value. And the reason why they increase is that the securities they hold increase in value.
They could also distribute dividends that you then reinvest to get the compounding effect.
Let me make it clearer by giving you an example.
The S&P500 has returned an average of roughly 10% annually since its inception, dividends included. Some years it goes up and some years it goes down, but the average is 10%.
So let’s use the average return and look at how the compounding would work. Imagine investing $10,000 in an S&P500 index fund 20 years ago.
- The first year, with the average return of 10%, your investment would have increased to $11,000.
- The second year, you would have gotten a 10% return on $11,000 and ending up with $12,100 (a $1,100 return.)
- Year three, you get a return of $1,210 for a total of $13,310.
- In the final year, year twenty, your original investment of $10,000 would have snowballed to $67,274, a return of $57,274.
But how could $10,000 snowball into $67,274? Isn’t a return of 10% per year for twenty years a 200% return?
The answers are: 1. Compounding. 2. No, not when compounded.
10% per year for twenty years, compounded, results in a 572% return. But that is only if you leave your investment be. If you instead had taken the profit each year and only left the $10,000 invested, you would have earned $30,000 instead of $67,274. That’s less than half.
For example, let’s assume that you invested $10,000 twenty years ago and you had an average annual return of 10%.
- The first year, like with the last example, you make a return of 10% for a total of $11,000. You then sell the $1,000 profit of the year.
- In the second year, you, again, have $10,000 since you took the profit. And again, you earn 10% on $10,000. You then sell the $1,000.
- The third year, you… I think you get the idea.
Compounding works by reinvesting profits, or in this case, leaving them be.
Compounding Dividends from Index Funds
I briefly mentioned that in the S&P500 average return of 10%, the dividends were included. Yes, most index funds pay dividends.
For example, in the S&P500, many companies distribute dividends. The index funds owning these companies are then required by law to redistribute any of the dividends they receive to the funds’ shareholders.
It differs between index funds, how this works. One index fund may distribute dividends as cash to its shareholders, while other funds may automatically reinvest them on behalf of the shareholders.
Some funds even let you choose how you want the dividends to be distributed. But the important thing is that, for the compounding effect to work, the dividends should be reinvested.
If you want to know more about index funds and how they distribute dividends, here is an article explaining it.
Compounding interest is a powerful way to build wealth over time, whether through ETFs, index funds, or individually chosen stocks.
It works by earning interest on your reinvested interest, or in the case of ETFs and index funds, earning returns on your reinvested (or left-alone) profits.
In order to fully utilize the compounding effect, dividends should be reinvested. In index funds and ETFs, this is often automatic but in some cases, you’ll receive the dividends as cash, in which case you must reinvest them yourself.