Hi everyone, I have a question about compound interest. When explained, it seems simple enough. But I get stuck at a thought and I'd really appreciate someone clearing it up. So quick fictional example: let's say I buy $10K worth of $TSLA and it grows 20% per year, indefinitely. Year 0: 10K Year 1: 12K Year 2: 14.4K Year 3: 17,280 etc. Compound Interest. Now my question is: If my 10K investment grows 20% in a single day, and again 20% the next day, will I have made 40% on my 10K investment so $14K? Or will I have already started the compound interest on the second day, since I closed at $12K the first day, and now have $14.4K the second day? It's basically a question of the "cut-off date" for compound interest to go into effect. Perhaps I'm thinking about it all wrong and you can enlighten me. Thanks!
No, you will have $14,400. You understand that after Day 1 you would have $12,000. Well if the next day you had $14,000 then it only went up 16.7% on Day 2. And it went up 40% in 2 days. When you are getting 20% per day, then the progression is $10k, $12k, $14.4k, etc. If it is going up 40% in 2 days, then on Day 0 you have $10k, Day 1 could be anything, Day 2 $14k, Day 3 could be anything, Day 4 $19.6k, etc. If it is going up 20% per day, then on Day 0 you have $10k, Day 1 $12k, Day 2 $14.4k, Day 3 $17,280, Day 4 $20,736, etc.
I'm not sure that's compound interest. Capital gains in stocks can't compound because there is nothing to compound. Compound interest happens because the banks are collecting interest and building off that. or, Compound dividends happen when you reinvest the dividends. But if you invest in Tesla and the value goes up 20%, that doesn't compound in the sense that you're talking about.
right.. but so then what is the most straight forward real-world practice of compounding interest for a good retirement? Because that’s the example which is always given. “If you start young you can compound interest your whole life and end up a millionaire”. So what are they talking about in the real world then?
It is compounding. Your investment goes up 20% one year and 20% the next year, and you made 44% in 2 years. If it was simple interest you would only have 40% in 2 years. When you leave your money in Tesla after the first year, all of your investment (the original investment AND the capital gains) grow 20% in the 2nd year. That is compounding.
I think you are mistaking interest with capital gains. In the financial world, INTEREST compounds daily. Approximate example. Take 2% and divide it by 360 and that will give your daily interest rate on the principal amount that is paid on a daily rate. Stocks, 10,000 invested today with a 20% gain 12,000 12,000 with a 20% return 14,400 and so forth. These type gains are impossible to achieve, just using your example. Capital gains are not guaranteed and fluctuate daily. They are not REALIZED until you close out your position. Money market funds, bonds are at historic lows, but for the slow grow mentality they will offer COMPOUNDED INTEREST over the duration.
Another way to think of it is this: You invest 10k in TSLA, earn 20% over whatever period of time, you have 12k. You sell and invest the 12k in MSFT. You gain 20% and sell and you now have 14.4k. Some investors take such an approach. I kinda have too but haven't been doing it long enough to swear by it.
The problem with the example here is that 20% increase isn't a result of compounding. Sure, 20% one day, then 20% another is compounding (in a mathematical sense) but realistically, that 20% has nothing to do with compounding. Maybe the company did something great and it's value went up 20% - that isn't compounding, that's the business doing well. Here is an example of stocks compounding: I invest $1K at 7% The next month, I receive $5.83 in dividends and reinvest it the same stock. Now I have $1,005.83 @ 7%. The next month, I receive $5.87. I reinvest in the same stock. Now I have $1,011.70. The next month, I receive $5.90.I reinvest in the same stock. repeat Notice that the dividends each month gets larger? That is compounding. My original plan was to use dividends to pay back a loan, but then I saw how much more money I could get from compounding those dividends and have switched to doing that. Here is a link to the spreadsheet in the video. I stress enough how powerful compounding is! https://1drv.ms/x/s!AkX5GgH_9WH5gx0BSJ54CBNtcdZz?e=KVWPjf
I’m still confused after watching this video: check timestamp 3:08. He says the S&P 500 has gained 270,000% since 1945. In 1945, the S&P was worth $15. Let’s say I bought 100 shares at that time worth $1500. My shares would now be worth $400,000 at $4k a share. That’s an increase of 26,500% or so. It misses a zero. See my point? What am I not getting here?
Off course you can make a nice Excel sheet with your stock investment and the overall performance from year to year and then use that to calculate the price of the stock in 10, 20 or 30 years. $100,000 stock in 10 years based on 5 % growth p/a = $162,889 $100,000 stock in 10 years based on 10% growth p/a = $259,374 $100,000 stock in 10 years based on 20% growth p/a = $619,173 So in 20 years we are all millionaires....
So when people use the word "compounding", does that also relate to the business reinvesting money into themselves for greater profit? I always understood the term as reinvesting dividends. But I guess technically, capital gains is compounding when a business reinvests their profit to make more profit. While this is mathematically true, I'm wondering what the general public thinks of when they say "let your investments compound". And then my 2nd question, or thought, is that I like dividends more because it's up to you - you're in control. With the business, you're much more passive and it's more of a gamble - will the company use their money well? You have no idea.... well, I guess you have some idea based on any news from the business.
