What is the Magic of Compound Interest?
“Everyone has the brainpower to follow the stock market. If you made it through fifth-grade math, you can do it.”
One of the greatest investors of our time attests to the simplicity of investing in the stock market. Find out how compounding stocks, compound investing, compounded interest all lead to more money with less effort.
The definition of compound returns is simple. Compound returns represents an initial investment plus the added interest, dividends, and/or capital gains growth over time. Think of a snowball rolling down a hill and the small ball at the top is your initial investment. As the ball rolls down the hill, the added snow represents the growth of the investment through additional money from interest, capital gains and dividends added to the principal amount. At the bottom of the hill is a big snowball!
Where Does the Magic of Compounding Stocks Come From?
Savings accounts, money market funds, stock, bond, and other funds represent businesses. The historical long term growth of American business is amazing. American business is frequently represented by the Standard and Poor’s 500 Stock Index (S& P500). This index of 500 stocks is considered a barometer for the US Stock Market.
Despite recessions and periodic bear markets, investment returns have trended up, over long periods of time. When looking at these returns, think about the stock market as a collection of U.S. businesses, not mutual fund or brokerage account statements. Then ask yourself if you think U.S. businesses and the economy will grow over the next 20, 30, or 40 years?
Even though past performance doesn’t predict future returns, high quality companies can be expected to grow.
Compound Earnings vs. Compound Interest – What’s the Difference?
Compound interest is the additional interest payment you receive in your savings, money market, or checking account. If you have a $1,000 balance in your savings account and the interest rate is 1.0%, then you will receive a $10 interest payment.
The compounding period will determine how frequently the additional earnings are added to the $1,000. More frequent compounding leads to greater returns. With weekly compounding you’ll receive 1/52nd of $10.00 every week added to the original amount. With quarterly compounding you’ll receive 1/4th or $2.50 each quarter, added to the prior amount.
With quarterly compounding, at the end of year one you’ll have:
- 1st quarter $1002.50
- 2nd quarter $1002.50 + $2.506 = $1005.006
- 3rd quarter $1005.006 + $2.5125 = $1007.519
- 4th quarter $1007.519 + $2.5189 = $1010.04
Not too exciting, right? But, increase the interest rate to 2% and continue the compounding for 40 years, and at the end of the period, your initial $1000.00 will be worth $2.221.00. But if you’re interested in earning an investment return greater than one or two percent, then consider investing in the financial markets.
Compound Earnings with Stocks and Funds
Investing in the financial markets provides the opportunity for greater returns with compounding stocks and funds.
Over the past one hundred years or so, the S&P 500 has returned an annualized return of approximately 10.4% including reinvested dividends. That means the $1,000 your great grandparents invested in the stock market in 1923 would now be worth $20 million today. Notice that in the graph below, $1,000 was invested in the stock market in 1923 and by 2022, that $1,000 exploded to nearly $20 million. Initially, the compounding returns were slow, but during the last 30 years or so, the compounded returns accelerated, further demonstrating the importance of time in growing small amounts of money into large sums.
Compound investing is miraculous if you have 100 years. But you might only have 20, 30 or 40 years until you retire and need that large amount of money. Even over 30 years, with regular contributions into your 401k, IRA or taxable brokerage account you can generate earnings leading to a robust future value of wealth. The longer you invest in higher yielding stock, ETF, mutual funds and other financial assets, the more your original investments will grow.
It doesn’t matter if you invest in stocks, ETFs or mutual funds as long as you reinvest the dividends. The compounding process works the same. And if you’re interested in stocks or funds that have a history of increasing their dividends, then look for a dividend aristocrat fund.
How Often are Stocks Compounded
Dividends are paid usually paid quarterly on the number of shares. Many companies regularly increase their dividend payments, leading to more shares as you reinvest your dividend payments.
Dividends matter, as they contribute a large percent to the total growth of your overall return. Without dividnds, th and only considering capital appreciation, the S&P 500 returned 6.35% annually over the last 100 years, versus 10.4% with dividends reinvested.
Start Early to Harness the Power of Compounding with Stocks
Let’s compare Jack and Jill, each age 25 with similar personal financial situations.
At age 25, Jill invested $15,000 in an investment account with stocks and bonds. This diversified account earned 5.5% compounded annually. At age 50, her original investment was worth $57,200 ($15,000 x [1.055^25]), with no additional contributions.
Jack waited until age 35 to begin investing. At that time he invested the same $15,000 and earned the identical 5.5% return, compounded annually. When Jack reached age 50, his account balance was only $33,487 ($15,000 x [1.055^15]).
Because Jill started investing 10 years earlier, her $15,000 had more time to compound. Even though each invested the exact amount of money, and received the same annual average return, Jill’s investment earned $23,714 more than Jack’s.
Don’t worry if you don’t have a lump sum to invest now. Start now and invest a set amount every month to begin the investment compounding. You can invest in a 401k, IRA or a taxable brokerage account – or all three!
Whether you invest a lump sum, or contribute a set amount monthly, the annual return rate plus the amount of money invested are the factors that will contribute to your growth. Longer compounding periods and larger amounts lead to greater wealth. But, as we learned with Jack and Jill’s example, time will make up for a smaller amount of money invested.
Check out how $1,000 grows over 20, 30 and 40 years at various annual compounding rates. With the stock market offering a long term return higher than bonds and cash, many investors are willing to accept periodic losses for the expectation of greater long term returns.
Consider this, if you are in your 20’s, 30’s, or 40’s you have many years until retirement. You can stick some money in a brokerage account at one of the discount brokers like Fidelity, Vanguard or Schwab, invest that money in an S&P Index mutual fund or ETF and forget about it. Fast forward 20, 30, or 40 years, it is likely that your investment will have grown substantially! Even Rumplestilskin could try this and probably wake up a rich guy after sleeping for a really long time!
An easier way to invest might be to use a low-fee robo-advisor and have your investments managed by the pros.
Whether you have a lot or a little to invest, compounding stocks will lead to greater long term wealth.
Magic of Compounding Takeaway
- The more time you have, the greater chance you have to get wealthy.
- Over time, the stock market has been a wonderful way to accumulate wealth.
- Since the stock market is very volatile, only put money into the market that you can leave there for 5 years or more.
- Invest only in stock index mutual funds or exchange traded funds (ETF’s) unless you have a lot of money and want to devote hours per week to researching individual stocks.
- For the best low effort long term returns, automate! Have a regular amount automatically transferred in to a brokerage account each month from your paycheck or bank account.
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