Today we are going to look at the questions, “Do stocks compound interest?” and determine whether it’s true. First, let’s define compound interest. There are certain components and requirements for an investment to compound interest. If it doesn’t meet those requirements, then we can’t say it compounds interest.
What is Compound Interest made of?
- Initial Investment
- Fixed Interest Rate
There are plenty of online compound interest calculators, like this one at moneychimp, but I’ll break it down into smaller components for you:
The Initial calculation looks like this:
Initial investment amount * Interest rate = X1
Initial Investment + X1 (Amount earned) = New Total Amount (let’s label this new amount A).
A * Interest rate = X2……repeat the series infinitely
The money continues to grow and grow. In summary, you earn interest on an ever increasing amount. With each step, the new total amount is greater. Most importantly, you never end up with less than you began with.
Time is another element of compound interest. Typically, the interest rate is quoted in an annual time period. For example, if you have a 6 month CD, they’ll usually tell you the annual interest rate. To find out the 6 month rate, you’d just dividend it in half.
Another component of compound interest is auto re-investment. Many bonds don’t auto-reinvest, you get interest at the end and that’s that. You have to be careful, depending on the investment-some brokerages give you the ability to auto-reinvest with bonds. Without the auto reinvesting, you have SIMPLE INTEREST.
An Example Calculation of compound interest:
Let’s suppose you start with an initial investment of $1000 and your interest rate is 3.5% annually.
$1000 *.035 = $35
$1035 is how much you end up with. If you compound the interest for another year, you get $1071.23
Hopefully, the concept of compound interest is clear. Now, onto our question:
Do stocks compound Interest?
In short, stocks do not compound interest. How come?
There is no GUARANTEE with a stock. If you purchase a stock, it could be up or down 20% a year from now. A requirement for compound interest is a guaranteed amount. There’s no guesswork about how much you end up with at the end of the time period. So, stocks fail the first requirement for compound interest.
In addition, people don’t usually purchase a stock for a year, sell it, buy back in, and start all over again. In fact, most people advocate for a buy and hold (or similar) approach to stock investing. Therefore, stocks do not compound interest.
I was actually surprised at how many notable finance websites listed stocks as an investment that compounds interest. They clearly do not. Stocks can compound gains (and losses) though, the exact wording being super important.
Do Dividends Compound Interest?
No, dividends do not compound interest either. If you use the dividends to purchase more share, you could say that you are compounding your shares; however, it’s not INTEREST you are compounding. Once again, there is no guarantee and there is no fixed amount. Dividends can be cut and dividends change from one year to the next.
All that can be said is you are compounding shares if you re-invest the dividends. Similar with a Mutual Fund that is set up to auto purchase.
Lastly, many stocks and funds don’t automatically re-invest dividends, so in that case, there is definitely no compound interest. I think it bears repeating, do not treat dividend stocks as bonds or a CD paying a given interest amount.
What are investments that do offer COMPOUND INTEREST?
- Zero Coupon Bonds
- Money Market Accounts
- Savings Accounts
CD’s and Bonds are the most common investments that offer compound interest. Take note of the safety of these investments. The main risk of each of these investments is whether it will increase greater than inflation, whether you’ll have a loss of purchasing power. Hopefully that clears up the issues of compound interest and it’s relation to stocks.
Wishing you the best on your INVESTMENT JOURNEY!