Asked on 19 Nov 2018
Now I understand that compounding in powerful in a scenario where you’re getting paid interest on a loan kind of scenario. Your payments will grow exponentially as you keep getting interest on interest.
But in the stock market, where does compounding come into play? If I bought an index fund today at 100 dollars and 30 years from now the total index fund value is 100, well I earned nothing from it.
You need to understand the rational behind stocks and shares and dividends. We could look at it in this way.
1) company stocks are the "fair market value". If a business do well, it appreciates in value e.g 5% increase in stock value. Next year, if business does even better, the "fair market value" increases, but maybe only at 4%. So total gains of 9.2% of 2 years ago. We term this at capital appreciation. This is your compounding interest in play (in terms of stock value).
2) stock is more complex because the value is derived from market value and business. Business can fail, so stock price can fall. Hence its is more riskier than just compounding interest from savings account. (since savings accounts are from banks mostly go to loans).
I hope this gives a much clearer or alternative picture to look at stocks and shares.
Buy an ETF that automatically reinvests the dividends such as IWDA or EIMI.
When you buy index fund for $100 today, 30 years later it'll appreciate since the stocks themselves will gain in value. Compounding effect for stocks is when you re-invest dividends (in this case, the 'dividends work like interest')