How does compounding relate to investing in stocks?

Question

I am just beginning to learn about investing and am familiar with the concept of compounding. I hear experts talk about starting early so that compounding can work its magic. I can see how it works on say a savings account that pays monthly interest. But when the experts suggest investing in stocks because of the higher rate of return I'm not sure how compounding can apply since stocks don't pay interest they just increase (or decrease) in market value and only some pay regular dividends.

Answer 1

Good question.

It all relates to expected returns over time.

$10,000 invested in a savings account with a 2% return would be worth $18,114 in 30 yrs, or $22,080 in 40 yrs

$10,000 invested in a CD account with a 4% return would be worth $32,434 in 30 yrs, or 48,010 in 40 yrs.

However, $10,000 invested in the stock market at an 8% return (or appreciation in price) would be worth $100,627 in 30 yrs, or $217,245 in 40 yrs.

That's a big difference. And it's w/o additional funds being added, just compounding of the original amount.

The reason the compounding works with stocks is that over time, stocks tend to appreciate (as do their prices). Look at the price of LEAP or ICE over the last year or so to see what I mean. Or just look at the Dow Jones index. Here's a link so you can look at how the index (which you could invest in) has increased over time.

http://finance.yahoo.com/q/hp?s=%5EDJI

If you learn more about investing so that you don't have to settle for avg market returns, you'll do even better. And that's why educating yourself about things you might not know about investing is sooo important!

Hope that helps!

Answer 2

Compounding of stocks is not the same as a cash investment such as a bank account. However, the dividends earned from stocks that pay dividends can offset risk and at the same time mature into a nice income producing asset.

There are close to 120 stocks that pay dividends MONTHLY, yes monthly. The rates of dividend payout can very from 1% to 23% currently, dependant upon the stock of course. Each monthly dividend can be reinvest automaically* and therefore your dividend for next month will grow larger than the month before. To put it simply, think of it as the more shares you have the more dividends you get, so reinvesting and adding is a great tool. This is where the refernce to compounding comes in.

* sharebuilder.com offers automatic reinvestments for free, aslo only charge a $25.00 annual fee for an IRA, no other fees unless you buy or sell your positions. Me and my wife use it becuase we don't go crazy and invest in all kinds of assests, we lie income investing becuase we can recieve money each month whenever we choose.

Answer 3

It can work 3 ways for you when investing in stocks. It fact works better when investing in equities than it does with any other form. Here is how. First, if a company is growing at say 10% annually and you buy stock in that company, your investment tends to grow also at 10% annually. Some companies are actually growing more rapidly than that, but over a long period of time their growth tends to normalize to a more normal 10% or so. That 10% growth tends to grow upon itself. It compounds.

The second way is through long term capital appreciation tax deferred. There is no tax on capital appreciation, which is a very big advantage to investors. A 10% annual appreciation on which there is no taxes due, is a very big investment advantage. If you invest in companies that are growing at 10% or better annually and sit tight, there is no taxes.

The third way is through increased dividends. There are companies that tend to increase their dividends annually. such as BAC, USB, BBT, JNJ, GE.

Answer 4

The answer is simple and dividends don't necessarily have to be part of the equation (although dividends can play a part).

Assume you buy $10,000 worth of XYZ and in the first year it goes up 10%. You've made $1000 and now you have $11,000 worth of XYZ.

Assume it goes up 10% again the next year. Have you made another $1000? No, you've made $1100 because you had more XYZ to begin with.

And so on, and so on. Each year with a 10% gain (hypothetical, of course) you will make more and more money because the gain will be based on a larger and larger amount of XYZ (whether that's due to dividends, price appreciation, or a combination of both).

That's how compounding in stocks works.

Answer 5

The compounding effect is more "noticeable" in mutual funds or in dividend- paying stocks.( especially if they're monthly)
When the dividends are paid...they are re-invested...and next month (or year) you then have more shares..soooo, your dividend is bigger...and buys more shares...and next month, etc.
Now if you add in the fact that the share price may also rise... you really notice the compounding.
Example: I have a fund FNMIX ... when I first started collecting monthly divs ( thus shares) it was about $ 94.00 a month...gradually ( two years) they have increased to about $ 135.00. The percentage is the same, but it's just based on more shares.( ...and more next month, yada yada)
The same applys to funds that only pay and re-invest yearly...but it's just less " noticeable".

Answer 6

hi. i'm a Wealth supervisor in Inference Wealth administration amenities Pvt Ltd. First i might desire to tell you that many compaines purely for emotional play they call rules as baby plan etc., yet in actual experience they are comparable as their different plans. there's a scientific thank you to realize an investment selection. in view that some time horizon is long term that's superb in case you're taking fairness exposure as over the long era fairness has and could provide superb returns. Now in case you are able to quickly purchase shares then its superb yet once you dont have awareness and time to track your investments then Mutual fund is an outstanding selection. If there is to any extent further rationalization required then do be at liberty to e mail me.

Answer 7

Compounding doesn't really relate to stocks. You can, however, reinvest the dividends on the shares of stocks you receive. That will, over time, increase your dividend payout and ultimately your return. I guess you can consider it related to compounding.