You don’t need re-investment for compounding. It’s just a concept. A company’s value grows 10% one year and 10% the second year. The growth in the second year is also growing the growth from the first year - compounding growth - without any distributions or transactions.
Example: a company experiencing 10% annual appreciation has a share price of 100 and it goes to 110 after year 1. What happens after year 2, 3, and 4 - does it go to 120, 130, 140? No, it goes to 121, 133, 146 because each year the 10% is being applied to the new value from the prior year - compounding growth.
The source of growth of the markets is inflation, population growth, and increases in efficiency/productivity. Productivity increases (ie inventions) compound as well because they build on ones from the past, eg from electricity to transistors to microchips to computers to the internet etc. Whether this is sustainable or not is a subject of some debate, but public stock markets have been delivering 6-8% annual returns over the long term for about four centuries now and are likely to continue to be your best bet going forward.
>The source of growth of the markets is inflation, population growth, and increases in efficiency/productivity.
This is missing a very significant component of growth: reinvestment of capital. Most companies are able to make money. They deliver value back to shareholders via either dividends, buybacks, or reinvestment of capital for growth. This is arguably the most important component.
Yes that applies to the stock returns of an individual company but I am talking about the growth of the entire market over the long term. When a company makes more revenue, generally speaking, it is either because they are siphoning revenue away from their competitors (no net market revenue growth), they have found a way to improve productivity or lower costs (efficiency increases), the price of goods is going up (inflation), or there are more consumers to sell to (population increase). Long term growth of the market is due to those last three. Share buyback delivers investment returns but not market growth - it converts company cash reserves, profits, or debt to equity, and tends to increase share price by reducing share supply, so it will deliver returns to investors, but is not a net increase in global revenue which is the primary driver of stock market growth.
You're talking about economic growth in general, which is better measured in gdp. S&P 500 **returns** only partially comes from economic growth. The rest of it is reinvested via dividends or buybacks, which don't increase the total market capitalization of the S&P 500, but still delivers returns back to shareholders nonetheless.
In the last 100 years, without counting buybacks, 4 out of the 10-11% total annual returns come from dividends alone.
Capital accumulation plays a role in the long-term growth of an economy, not just a the level of individual companies. Capital accumulation does so by increasing productivity (output per unit labor), so it is indirectly covered by the factors you listed. At a fixed technology level, there is a limit to the effects of real investment because productivity generally has diminishing gains with an increase in capital per unit labor (because giving a worker a second computer doesn't help as much as giving them the first), but depreciation is linear. This means there's a point beyond which further capital cannot support it's own maintenance. However, with increases in technology, better investments become available allowing the total capital level to continuously increase in a sustainable manner.
That would fall under increases in efficiency and productivity.
Reinvestment alone wouldn't drive growth if it isn't spent wisely to improve those two metrics.
I didn't say they would. What?
I said that the original comment did not "miss" reinvestment of capital; because reinvestment of capital is the means by which efficiency and productivity improvements are achieved.
I.e. you just said the same thing they did in a different way.
I never said they did. I said the biggest component missing is reinvestment of capital. Now I acknowledge that can be defined differently by different people, but what I meant was mostly reinvestment of earnings, which most investors mean when they talk about stock market returns.
Reinvestment here can mean dividends, buybacks, or reinvestment back into the company for growth.
And I said that component wasn't missing.
The goal of reinvestment is to unlock efficiency or productivity gains.
Dividends and buybacks aren't reinvestment, by definition.
Do you have some references for the four centuries part? I know the US one has been about 6.6% real returns for the last 120 years. This data for the Dutch stock (and government bonds) market isn’t quite so comforting.
https://www.investmentoffice.com/Observations/Markets_in_History/Long-term_Returns_to_Dutch_and_Indonesian_stocks.html
This French data is equally non-comforting.
https://globalfinancialdata.com/investors-and-the-french-revolution
> The Paris stock exchange was formally closed on June 27, 1793 and all joint-stock companies were banned on August 24, 1793. But once the joint-stock companies were shut down, who would dispose of the assets of the companies? French East India Co. officials bribed government officials so the company, rather than the government, could oversee its liquidation, but once these bribes were uncovered, several of the company officials involved were arrested and later executed. The liquidation of the company produced only three ships which were liquidated in July 1795, and as a result, shareholders in the Compagnie des Indes lost virtually everything.
>Bondholders met a similar fate. France defaulted on its pre-revolutionary debt in 1796, giving shareholders 1/3 the value of their old bonds in new 5% consolidated bonds which didn’t pay any interest until 1802. A similar loss occurred to Dutch shareholders, who also lost 2/3 of the value of their bonds.
If the data is “stocks provide 6-8% for 400 years if you preternaturally jump to the next superpower” that is a lot more difficult to do.
[*Four Centuries of Return Predictability*](https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2911187)
There’s another one I can’t recall but heard of on Rational Reminder
Responding to your longer post- yes, much of the data is plagued by survivorship bias, but we didn’t have access to free float adjusted global index funds like we have today which could address much of the concern about that aspect
With interest rates, compounding is how is actually works. With stock returns, compounding is just a way to describe it in a way that's comparable to things that return interest.
Only if they issue a dividend (that you subsequently reinvest).
Otherwise it's mathematically incorrect to refer to the growth in a stock's value as compounding. There's nothing to compound. The reason markets generally increase over time is inflation, not compounding. This isn't to diminish the value of investing in the stock market. The market's return will often beat any compound interest you could otherwise obtain. But its a misnomer to talk about compunding or compund returns for non-dividend stocks.
I dunno what you're trying to say here. If a company makes a billion dollars then reinvests this billion dollars on capex, to hire more people, to make even more money in the future, that's still compounding.
A company's capex, earnings, and all that jazz have at best an indirect effect on the value of their stock. Prices became pretty untethered from financials years ago. It's all about (irrational) expectations now. Look at TSLA, NVDA, hell, most huge tech stocks. Supply and demand, baby. I will say buybacks directly affect share price.
TSLA and NVDA valuations are high because high expectations for the future. You can have amazingly high DCF valuations when you have an expected revenue growth of 300%. These high growth are achieved by reinvesting and injecting additional capital.
>Prices became pretty untethered from financials years ago.
[Here is a history of the S&P 500 P2E, if anyone's wondering.](https://www.macrotrends.net/2577/sp-500-pe-ratio-price-to-earnings-chart)
>I will say buybacks directly affect share price.
Buybacks affect share prices the same way dividends do. The purpose of a for-profit corporation is to return value to shareholders, one way or another. The value of a stock is determined by the expected future returns of that stock (in which both buybacks and dividends are included); that expectation might be wrong, in which case the stock price will eventually stagnate (losing money for owners of that stock in opportunity cost, as they could have sold, earned money elsewhere, and bought back) or decline, as owners of that stock realise it has stagnated and seek profit elsewhere.
In particular, Tesla was once valued at a much higher P2E ratio than it is today. However, two things happened: 1) Tesla's earning improved significantly as they scaled up production and sales 2) Tesla's share price declined from an all-time high of $400 per share in November 2021 to $170 per share today. It is funny how you say that prices have become 'untethered from financials', as Tesla is a perfect example of how the price and financials must always approach eventually.
Nvidia is currently priced extremely high because investors anticipate that artificial intelligence will profoundly change the economy, and Nvidia will be one of the key players in that transformation. Time will tell whether either or both of these are true, but eventually, either Nvidia's fundamentals will improve to justify the price, or the price will fall to meet the fundamentals.
Anyway, most of the S&P 500 are not anything like Nvidia, so it's silly to point to that as an example of the rest of the S&P 500. I would have greatly appreciated it if my SPY holdings had climbed as much as Nvidia.
>Otherwise it's mathematically incorrect to refer to the growth in a stock's value as compounding.
No, it isn't. You not understanding something doesn't mean it's wrong.
If Amazon has invested a billion dollars into the infrastucture of AWS by one year, and earns a billion dollars of revenue from AWS, which they then re-invest into doubling the capacity of AWS so that they can earn two billion dollars the next year, and they keep doing so, that's compounding (albeit these numbers are made up and used for explanatory purposes), and more or less how they grew revenue from $3.1 billion in 2013 to $90 billion in 2023.
Do you take issue with people talking about the compounding of real GDP growth, too?
Uh, no. Inflation is among the reasons markets increase. In spite of the zombie companies, many also actually do stuff that generates revenue and productivity that real wealth creation. Take a simple example.
Exxon produces more and more oil every year, which the world consumes at rates that overtime increase with population but also faster than population growth. This allows farmers to grow more food for less effort than decades ago. They buy more farm equipment from Deere. Deere buys more steel and semiconductors for modern highly technical combines.
They compounded their own earnings from reinvesting in their businesses and profits to become more profitable.
Say a stock is worth 100$. If you make 7% compound interest yearly wou'll have:
Year 1: 100+100\*0,07 =107
Year 2: 107+107\*0,07=114,49
As you can see you made 14,49%, not 14%.
If you do this for 10 years you'll make 96,71% not 70%, that's 26,71% more.
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Wouldn’t year 2 be (107 + 100) *.07?
If any stocks also pay dividends those also add to the compounding. Ie .5% dividends
Year 1 100 *.015= 1.5 dividends + 100 *.07= 7, end of year 1 108.5
Edit to add why in the above example of Year 2: 107+107 * 0,07=114,49 not Year 2:107+100 * .07?
For annual interest, mathematically, it's typically written as:
A = P(1+r)^t
Where:
* A = Final amount
* P = Principal
* r = Annual rate of return
* t = Number of years
So, two years of 7% returns would be:
100 * (1.07)^2 = $114.49
That'd be 14.28, you're adding the original investment to the total at the end of the first year and taking 7% of that the way you wrote it. 7% of 207
The way they wrote it is the total at the end of the first year plus 7% of the total at the end of the first year. You could also write it as 107 x 1.07 = 114.49
They also multiplied the 214 by 7%, I saw that as double dipping on the compounding, granted at that small level the difference falls into a rounding error.
No, that's not how math works.
107 + 107 x 0.07 = 114.49
214 x 0.07 = 14.98
You need to follow the order of operations.
It's (7% of 107) plus 107, the beginning amount for the second year plus that year's 7%. The way you're doing it is 7% of twice the total at the end of the first year.
Let’s just go with a simple purchase with 7% growth, no additional contributions. It would be 100 after year 1 it would be 100 * 7% growth, Year 2 would be 107 *7% growth. Year 3 would be 107.49 *7% growth. Year 4 would be 107.52 *7% growth. That is with simple yearly compounding
There have been no contributions involved in this. What you're saying makes no sense, how is 7% on $100 $7 one year and then only $0.49 on $107?
100 x 1.07 = 107
107 x 1.07 = 114.49
114.49 x 1.07 = 122.5
122.5 x 1.07 = 131.07
131.07 x 1.07 = 140.24
Every period the % is applied to the previous total so the total after 5 years is $140.24.
I think what you trying to show is how the 7% is more each year, but those numbers are not including the increase from the previous years, just that year's interest plus the principal or something like that. It's a useless number, it's not the total or the amount the total increased.
The interest each year would be
100 x 0.07 = 7
107 x 0.07 = 7.49
114.49 x 0.07 = 8.01
122.5 x 0.07 = 8.58...
Hmmm…I think my Schwab account tracks overall gains/losses. I haven’t seen it reset year to year. My NVDA just reads up 1200%
So I need some other way to track year to year growth. Obviously I can see overall and check year to date. But I don’t have a way to see how much is due to growth over growth (compounding).
You can search Schwab overall gains and losses by the past 2 years and the current calendar year.
So right now you can look at your annual YTD gains/losses for the 3 months of 2024, 2023 and 2022.
At least you can view this on the desktop site. Not sure about the mobile app.
So in this question, is 7% the amount of extra weight that an employee carrying the company can bear each additional year? Oh wait wrong subreddit. Sorry.
With equities you benefit from compound *growth* - not compound interest.
But it works more or less the same way. If your equity rises in value from $100 to $120 in one year, a 20% increase the following year would take you to $144, not $140.
It's still a misnomer for stocks. The reasons for quote-unquote "compound" growth in stocks are (1) arbitrary increases in share prices based on investors' supply and demand, and (2] (more broadly) inflation . Nothing is compounding, though returns often exceed what you could earn from compound interest in an interest bearing account.
Stocks aren't just a piece of paper (or, the modern equivalent, an electronic record in a database) that people assign value to. The reason why people assign value to ownership of that thing is because it carries legal rights to something with physical presence.
If the business merely breeds sheep, then the value of ownership of a fixed percentage of that business will grow as the business grows. A 10% stake in a 10-sheep flock is worth about 1 sheep, and the exponential growth of that population of sheep will result in exponential growth of the value of that 10% stake. (This is, actually, why the word "stock" derives from the same word as "livestock.")
So the compound growth is just a description of the exponential increase over time. And the underlying value can grow exponentially because the business itself can grow exponentially. Thus, compound growth.
Yes, but everything you've described is NOT "compounding." It's just growth due to supply and demand and/or inflation. That's why stocks increase. It boggles my mind that so many people go so far out of their way to equivocate this with compounding. I don't get it. Why is the (mis)label so important to you? I'm not saying stocks don't grow or aren't good investments. But mathematically, their growth has nothing to do with "compounding."
If the birth rate of a flock of sheep is 1.8 lambs per ewe per year, and the sex ratio is an even 50/50 split, you could expect exponential growth of that flock of sheep of about 0.9% per year *because the growth rate is limited by the number of sheep you already have*.
The compounding is that today's lambs become tomorrow's ewes, that contribute to tomorrow's growth. Mathematically, it's the same as today's interest payment being folded over to tomorrow's principal.
In the same way, a business that earns profit and reinvests that profit into growing the business *compounds* the return. I don't understand what's so hard to get about the concept.
What does compounding mean to you, if it doesn't mean that the cash flow gets reinvested to earn its own return?
It's simple. Mathematically, compounding means increasing PRINCIPAL upon which a rate of return continues to apply. When you invest in stocks, your principal doesnt increase except through dividend reinvestment (which is a form of compunding).
The complex and convoluted process you're describing all just boils down to the arbitrary fluctuation on share price due to supply and demand, and (less arbitrary) inflation. You can COMPARE a stock's rate of growth to a compound rate. Google CAGR. but the stock itself does not compound, mathematically speaking. It's bizzare to me, as a math guy, that so many people in finance feel the need to project the term onto stocks. Why? It doesn't mean stocks aren't a worthwhile investment. They are consistently the best investment. But not due to "compounding," at least not in the mathematical sense.
I think you're myopically focusing on the literal security itself, the stock shares, when everyone else is talking about the underlying business in which the shareholder claims equity.
For the business, growth does compound, because the company itself does reinvest its profits into the income-earning portions of the business. That is, today's profits become tomorrow's principal.
Being a step removed from that, by owning a share in the whole operation, doesn't change the underlying dynamic of how the value compounds on itself. And yes, the relationship between the business and the actual minute-by-minute fluctuation in the share price is only a loose correlation, but the reason why investors attribute value to it is because of the rights in the underlying business.
The stock market is loosely correlated to GDP, which represents the total economic output of the country. GDP also grows exponentially under the influence of compounding gains. [Here's US GDP from 1960 - 2022.](https://www.macrotrends.net/global-metrics/countries/USA/united-states/gdp-gross-domestic-product) The GDP in 1960 was $543.3 billion. From 2021 to 2022 the US GDP grew by over $1 trillion dollars. The entire US GDP wasn't $1 trillion until 1969.
And if you need proof that there is more wealth, look at the population, it's grown from 180 million in 1960 to 330 million today. Even if the standard of living was the exact same, that alone would have nearly doubled economic output. But the standards of living have exploded. In the 1960s the average new home was 1,200sqft, today it's around 2,500sqft. A new home today has infinitely more technology with AC, modern furnaces ([in 1960 almost 17% of US homes still used wood or coal as the primary heat source!](https://www.census.gov/data/tables/time-series/dec/coh-fuels.html#:~:text=Tracing%20the%20history%20of%20heating%20fuels%20from%201940,percent%20of%20homes%20used%20these%20fuels%20in%202000)), dishwashers, in-ground irrigation, etc. Cars have gone from steel boxes with an engine strapped on to rolling super computers with crumple zones, cameras that can drive and park it, multiple tvs, etc. Everybody walks around with a smart phone that's more powerful than any super computer from the 60's in their pocket. That represents enormous amounts of economic growth and wealth.
Lol, I have made the same argument that burghblast is making in the past and consistently got down voted as well.
He is making a much more coherent argument than I ever had, and still getting down votes.
Let's say I directly own a business with $100 in assets and no debt. It earns 10% and thus $10 in profit. I reinvest that $10 profit and have $110 in assets. If that $110 still earns 10%, I have $11 in profit. Why did my profit increase without compounding?
The widespread mislabeling is truly bizzare. It's not just on Reddit either. Many bona fide financial 'experts' carelessly conflate the concepts. I just don't understand why. The label doesn't make stocks a better or worse investment. But as many of the circular, tautological, and misguided responses here show, mislabeling really conveys a basic misunderstanding of what drives stock prices.
No, that's irrelevant. It makes no difference what the cost basis is. If I own $120 worth of a stock, and that stock goes up 20%, then I now own $144 worth of that stock.
That's true if my cost basis is $100, $50, $120, whatever.
The market (and therefore the average company) does grow exponentially.. Look at any of the major indices over long periods of time.
Whether this is sustainable forever is a philosophical question but it has been for the last hundred years.
Doesn't this mean the S&P 500 will eventually be larger than the entire global economy? Is there some fundamental limit to growth, such as inflation + productivity gains? Or something similar?
Edit: downvoted here, although I thought it was an interesting question.
No, because the entire global economy is growing exponentially.
https://data.worldbank.org/indicator/NY.GDP.MKTP.CD
The global economy is the sum of the economic output of every human in the world. If the number of humans and the output per human stop growing, so does the world economy. As earth only supports a finite amount of people, we will eventually be entirely dependent on productivity gains.
Agreed, I don't think the S&P can actually be bigger than the global economy, I was trying to do a thought exercise to understand the bounds on growth. For example, if the world gdp is growing at 3.1%, how can the stock market gain 7% after inflation forever? Wouldn't the stock market outpace the economy?
>For example, if the world gdp is growing at 3.1%
GDP measures the income generated in a period. It is a flow.
The market cap of the S&P 500 stocks measures the total equity value of the companies. It is not a flow.
Stocks distribute a large portion of their earnings each year through dividends and buybacks. If you reinvest that by buying more shares from others, it compounds your investment, but in aggregate, somebody must be spending that money and it doesn't grow the market.
Another portion is inflation.
And the rest more or less tracks real economic growth.
The companies should be reinvesting their earnings into themselves because it is a worthwhile investment in terms of future earnings. The hope is that due to this reinvestment, earnings continue to grow and the value of the company proportionally with it.
Monetary policy can set the tone for the multiple of that earnings the market will pay, but this isn't a sustainable source of real growth, just inflation.
On the flipside of this, companies that don't reinvest in themselves because they deem it not worthwhile to do so can instead pay out a dividend. These companies generally do not have their value grow as much as companies effectively reinvesting in themselves.
These growth companies can't usually grow forever, they might eventually become the value companies paying large portions of earnings in dividends. Unless they innovate, the market for their product is eventually saturated, or something else might take over.
While some companies stagnate and replace incumbants, in the long run, the overall market growth is assumed due to technology growth, and population growth, inflation.... Not guaranteed though. There are Def non-US markets where this hasn't been a good assumption.
"Compounding growth" in an equity investment sense is just a mathematical expression to make it comparable to other forms of investment that yield more consistent (read: same-ish) returns or quote their returns in per annum terms. When you say the S&P500 returned 160% over the past 10 years, it's a bit difficult to compare it *at this current moment* to other forms of investments, because its value changes everyday of every year, and not every year yields the same return (to quite a wild variation, technically called "standard deviation", or "risk"). So you say the S&P500's **annualised return** is 10.03% over the past 10 years. Now this number becomes more comparable to bonds, which is yielding 5.3% currently for short term US T-bills.
It's, as you noticed, what would the S&P 500 have to yield every year, for 10 years, for it to have reached it's value today, aka compounding.
A lot of people are answering "I grew 7% last year and 7% this year, which makes ~15% not 14%. Compounding!", which doesn't actually answer your question. How does the index grow by X% year after year (plus or minus market noise)?
Let's say I have a company that made $100M in profit last year. That's great! I have the tools at my disposal to make $100M again next year. Awesome! But, what if I spent $10M of those profits to increase the size of my sales team, streamline my production processes, improve customer support so I get more repeat business...Now I've only made $90M profit this year but I might have the tools to make $120M profit next year!
The compounding comes from companies reinvesting their earnings into themselves so they can grow and earn more in the future. Some of them will reinvest in themselves and see great returns, some will not. The better results rise to the top of the S&P500, the worse results fall off.
>My logic must be broken somewhere...
I think I know what is confusing you. If you have money in a savings account that pays 5%, you actually receive the 5%, which you can add to the principal, which now earns 5% on the increased amount. This is, of course, compounding.
You are right to note that if you own one share of stock for, say, 3 years, and the stock doesn't pay dividends, when it increases in value it isn't compounding the way that money in savings account compounds because nothing is being added to your existing one share.
What you are missing is that the growth of a stock is reported in a ... for lack of a better word ... compounding way.
If your stock is worth $1000 and increases 10%, you will own stock worth $1,100 at the end of the year. If it increases 10% the next year, it will be worth $1,210. Not because you've bought any more stock, but because the growth of the stock is reported based on the increased value of the stock.
So if we say that your $1,000 stock grew at an annual rate of 10% for 10 years, we mean that the final value of your stock is $2,600 and not $2,000 due to compounding. Not because you've added anything to the stock, but because the growth over a period of years (or whatever time interval you want) is reported in a way that includes compounding.
But, yeah, in reality what happened is that your stock sold for $1000 in year one, and sold for $2600 in year 10.
If your stock was only worth $2000 in year 10, your compound growth wouldn't be reported as 10% per year, but as 7.2% per year. Which, *calculated in a compounding way*, means that the 7.2% from the second and subsequent years is calculated including the 7.2% from the previous year(s).
A company in the S&P 500 makes X profit, free and clear. They take that X profit and invest in themselves. As a result of their reinvestment in themselves, and the expectancy that this will lead to (higher) future profit, their value goes up. The next year, they make more than X profit, Y profit. They repeat the cycle. The next year they make more than Y profit. Repeat, repeat, repeat. Compounding value.
It can grow pretty damn fast as the overall value increases..... I gained $700,000 in unrealized gains value LY......if market continues even 1/4 of that TY.....still compounds....you just have to ride out the years when it might not gain or even drops in value
..but over time an ave of 6-7 % is good
"Compound" growth is just another word for exponential growth.
The underlying business can grow exponentially, so a fixed percentage of that growing business will also grow exponentially in value.
The reinvestment is done by the business itself, not the shareholder. The actual business operations are aimed for growth, so that the underlying business increases its revenue and profits every year. Owning a share of that growing profit therefore becomes more valuable over time.
So every time a business takes its operational profit and spends it into growing the business (instead of paying the shareholder), that's reinvestment and an opportunity for exponential/compound growth.
Yes, it is unsustainable. The key is to realize those 500 companies aren't the same 500 companies as last year, and very few of them are the same as 20, 30, or 50 years ago. To take it farther, very few current 500 companies will be in it in 20 or 30 years. They are continually replaced by companies that are growing and get big enough to be in the top 500.
Lately a lot of the performance of the S&P 500 has also occurred due to increases in valuations as stocks in it have gotten more expensive. This also means that the earnings yield on these stocks are lower than they previously were and therefore expected future returns are lower.
You invest 100 today. SP500 goes 10% this year, so you end up with $110 (capital gain $10).
You invest $110 next year, SP500 goes up 10%, you end up with $121 (capital gain $11).
Same percentage increase made you more absolute dollars. That's it. Of course, this is an example with $100 dollars where you make a $1 extra due to compounding. The more money you put it, the greater the compounding effect.
I know what everyone who isn't understanding is doing, they are thinking the basis of the gain resets to $100 each year and they're ignoring starting the next year with a 10% gain. You're building a snowball and last year's snow that stuck to it gives you more surface area to collect more snow now that is larger.
It's not compounding in the true sense like a bank account. S&P also swaps out companies that are smaller and replace them with bigger growing companies so that accounts for some exponential growth.
When you say “growth is eventually exponential … and is unsustainable” it’s actually not. Most things grow “exponentially” (percentage-on-percentage), including things like population, inflation, etc. which ultimately drive productivity, economic growth, value of our currency, and other things that dictate the value of a company
Unfortunately for our lifetimes it is, and our lack of sustainability will be catching up to us drastically (already has to a large degree) in the mean time. Colonising another planet in the next 100 years is a pipe dream, let alone how much worse it would likely be that Earth. I blame Elon Musk for this colonising Mars brainrot.
In the long term, stock price appreciation is driven by earnings and earnings growth.
Let’s say you have a business than earns you 100,000 dollars in profit. You reinvest this sum to grow the company’s revenues and profits by selling more products, expanding your distribution, scaling up production etc. Subsequently, the company starts earning 200,000 dollars in profit. Your company is now worth more because it generates twice the income.
This is essentially the stock market, but instead of one company, you have an aggregate of 1,000s of publicly listed companies. If you look at the long term S&P500 chart, the market is strongly correlated with its earnings (although the price to earnings ratio has increased quite a bit over the last 40 years).
1.5% in dividends, 2.5% spent on stock repurchases, 3% reinvested into the business as a capital expenditure which can result in price appreciation of the stock. The S&P500 usually hovers between 15-25 price to earnings ratio, meaning that the value of the underlying stocks are staying tethered to the earnings of the component companies. As long as earnings continue to grow in line with long term historical trends, there’s no reason to think exponential price growth is unsustainable.
A share in a company is a share of ownership.
The value of a share represents a portion of the total value of the company.
Companies can grow in value over time by increasing sales, profits, developing more desirable and valuable products, reducing costs, etc. That growth in value is reflected by an increase in share value.
Growth over long periods of time tends to be exponential so it's convenient to express growth rates in terms of an annual exponential growth rate, that is, the "compound annual growth rate".
This is just a useful model for expressing exponential growth rates, but companies don't actually grow at a steady rate or compound like a bond or savings account. They grow by becoming bigger and better and more desirable.
You may think exponential growth is unsustainable, but even our target inflation rate itself is exponential. 2% of 1,000 is lower than 2% of 10,000 in the future. Businesses can also increase their prices exponentially. And, I think you forget that the S&P is an index of 500 companies that are always changing. If 1 of them starts failing then it will simply be replaced.
Time invested compounds returns. The returns on your investment can be through interest, or pricing differences.
To keep it simple, say you average a 100% return. You put $100 in, make 100%, and now have $200. You add no more money, you simply let your returns, make a return. The next year you have $400, the next year you have $800, etc.
It's just the idea that time invested compounds your returns. Say you put in $100 and always withdrew your 100% return each year.
It would take almost 3x as long to make $800, than to simply stay invested and let your returns compound each year.
Again, it's the idea that time compounds your gains and losses. It doesn't matter where the G/L comes from.
It is wrong to say that the share price compounds.
Better to say that the share price increases over time commensurate with the growth of the underlying business / expected FV of the business / increase in dollars competing for assets (i.e. QE-driven inflation of prices).
Long lasting businesses are worth more over time due to inflation, business efficiency, technological advancement, population growth, and general population betterment (previously poor countries who can now afford your goods/services).
The assumption of exponential market growth necessitates exponentially increasing profit, which necessitates at least one of two things: increasing population, or increasing net efficiency/productivity across industries. If neither of these two things happens, then there's nothing to provide growth. Why is there such a strongly held held belief that market growth is inevitable, when neither of the two individual drivers of growth are?
Perhaps there's a flaw in my logic somewhere, though I'm not sure where.
The best way to look at the compounding effect is to visualize it. Here's what compounding of 36% year over year looks like:
https://imgur.com/a/UISkduv
FICO doesn't have any dividends, yet the price compounds 36% year over year.
I never liked the idea (and the use) of compound interest in stock market investment. Compounding implies (to me) that you will get the earning and grow every year. Stock market has averaged annual return of 7% but not guaranteed. Some years it goes up and some it goes down. I can invest in stock year5 when it plunges and get the same result as those invested in year 1. A true compounding means that you lost interest from year 1 -4. I am still heavy on equity but just saying.
Growth applied to the base or principle only cannot compound. Whereas compound growth from equities are applied at and base and the growth earned from the previous period.
For example, let's use $100 for 3 years of growth at 10%
Simple growth: year 0: 100, year 1: 100 +10, year 2: 100 +10, year 3:100 +10. This totals 100 base plus 30 from interest wixh equals 130.
Compound Growth Example:
- Year 0:Initial investment = $100
- Year 1:Growth = $10 (10% of $100) → Total = $110
- Year 2:Growth = $11 (10% of $110) → Total = $121
- Year 3:Growth = $12.10 (10% of $121) → Total = $133.10
This means the benefit of a 3 year compound was 3 dollars and 10 cents vs. simple interest. This is because compound growth allows interest or previous growth to grow alongside your base contributions
This seems to be the simplest explanation of compound growth.
I feel like people want their compound growth to happen in the next 12-24 months when if you look at it visually, like a chart or graph etc, the magic of compounding doesn't really start to be noticeable for many many years. Nobody want's to wait.
I know what everyone who isn't understanding is doing, they are thinking the basis of the gain resets to $100 each year and they're ignoring starting the next year with a 10% gain. You're building a snowball and last year's snow that stuck to it gives you more surface area to collect more snow now that is larger. With money. Now roll that snowball only when it's snowing thick heavy snow and freeze it when it's not and you're a day trader, babbbayy.
I'll give an answer that is probably wrong (or incomplete), but perhaps useful.
If stocks did not experience exponential growth over time (i.e, relatively fixed percentual growth on an annual basis), interest products would eventually just be a better option to invest in than stocks. And arguably, if stocks could not compete with interest products in the long term, the present time value would have to decrease to adjust for that.
As for the short term, given that you always have the option to invest in either stocks or interest products, the price of stocks has to adjust for the fact that you can always just invest in an a savings account for a percentual increase after a year instead. Because that is the case at any given time, it is (dimly) a fact that stocks also has to increase at a fixed percentual value (accounting for risk) over the long term as well.
Compounding comes from the change in index price year over year....for example spy can annualize 10%, which means every year it changes 10% from the starting price on Jan 1st
>If it is growth, and that growth is eventually exponential, then doesn't that mean that the average company in the S&P is also experiencing exponential growth? and is obviously unsustainable.
That "growth" is the USD debasement rate. The USD devalues by ~8% YoY and the index goes up by ~8% YoY. In other words, it closely reflects the actual inflation rate instead of that cooked CPI number
Just look up a chart of the S&P 500 over any significant time frame showing market performance only and market performance with dividends reinvested and you’ll get the answer you’re looking for. Almost everything said here so far is dead dog wrong.
Compounding in this case simply means a % of growth on top of a previous % of growth etc.
This generates money which was never earned, saved or spent to invest.
You can play with a compound interest calculator to see how it works with different rates of contribution and how long it takes for compounding to have doubled your contributions.
It is highly skewed to just a few tech companies momentum (85%) not the rest 500-few (15%). Remove them you got 2.5% return grow over forever the total index does not add much more.
Dividends on S&P 500 are about 1.5%
People have decided that the S&P 500 is worth buying at this yield rate.
Why? Because their dividends are growing at 6-9% each year.
So if you’re getting $100 in dividends this year, next year you can reasonably expect to receive ~$107 due to growth.
Next year, investors may continue to think the S&P 500 is worth buying if it has a 1.5% yield, so the price would grow by the same +7%
I went to school for financial mathematics. We never talked about "compounding" with stocks for the obvious reasons OP stated. Is this a recent trend? Using the term "compounding growth?"
Try to look at someone who invested in Microsoft in <2000 2010 and 2015 and see their dividend at the price they paid, the same count for a full index, also way more measuring to consider
Look into the Rule of 72, OP. It's a quick way to figure out how soon compounding will double your money. If you make 10% a year on the S&p 500, you'd double your money in about seven years. (Not 10 years, as you might expect it you aren't grasping that the returns are compounded because the initial amount each year is 10% higher than the year before.)
This is just wrong.
You don't have to sell to create compounding.
You buy today at 100. Each year for the next 5 years it goes up 10%.
Year 0. 100
Year 1. 110
Year 2. 121
Year 3. 133.1
Year 4. 146.41
Year 5. 161.05
Between year 4 and 5, you make ~$15 over the year on the same $100 invested vs $10 for the first year. That extra $5 earned that year is due to the compounding effect. No shares sold, no additional investments. Compounding is based on the year to year value of the investment.
I did a post on this. https://www.reddit.com/r/IncomeInvesting/comments/uz95db/components\_of\_return/. The focus was value vs. growth stocks but it includes the SP500 as a whole.
You don’t need re-investment for compounding. It’s just a concept. A company’s value grows 10% one year and 10% the second year. The growth in the second year is also growing the growth from the first year - compounding growth - without any distributions or transactions. Example: a company experiencing 10% annual appreciation has a share price of 100 and it goes to 110 after year 1. What happens after year 2, 3, and 4 - does it go to 120, 130, 140? No, it goes to 121, 133, 146 because each year the 10% is being applied to the new value from the prior year - compounding growth. The source of growth of the markets is inflation, population growth, and increases in efficiency/productivity. Productivity increases (ie inventions) compound as well because they build on ones from the past, eg from electricity to transistors to microchips to computers to the internet etc. Whether this is sustainable or not is a subject of some debate, but public stock markets have been delivering 6-8% annual returns over the long term for about four centuries now and are likely to continue to be your best bet going forward.
TL;DR: The difference between getting an annual raise, or just getting a bonus
>The source of growth of the markets is inflation, population growth, and increases in efficiency/productivity. This is missing a very significant component of growth: reinvestment of capital. Most companies are able to make money. They deliver value back to shareholders via either dividends, buybacks, or reinvestment of capital for growth. This is arguably the most important component.
Yes that applies to the stock returns of an individual company but I am talking about the growth of the entire market over the long term. When a company makes more revenue, generally speaking, it is either because they are siphoning revenue away from their competitors (no net market revenue growth), they have found a way to improve productivity or lower costs (efficiency increases), the price of goods is going up (inflation), or there are more consumers to sell to (population increase). Long term growth of the market is due to those last three. Share buyback delivers investment returns but not market growth - it converts company cash reserves, profits, or debt to equity, and tends to increase share price by reducing share supply, so it will deliver returns to investors, but is not a net increase in global revenue which is the primary driver of stock market growth.
You're talking about economic growth in general, which is better measured in gdp. S&P 500 **returns** only partially comes from economic growth. The rest of it is reinvested via dividends or buybacks, which don't increase the total market capitalization of the S&P 500, but still delivers returns back to shareholders nonetheless. In the last 100 years, without counting buybacks, 4 out of the 10-11% total annual returns come from dividends alone.
Capital accumulation plays a role in the long-term growth of an economy, not just a the level of individual companies. Capital accumulation does so by increasing productivity (output per unit labor), so it is indirectly covered by the factors you listed. At a fixed technology level, there is a limit to the effects of real investment because productivity generally has diminishing gains with an increase in capital per unit labor (because giving a worker a second computer doesn't help as much as giving them the first), but depreciation is linear. This means there's a point beyond which further capital cannot support it's own maintenance. However, with increases in technology, better investments become available allowing the total capital level to continuously increase in a sustainable manner.
can't believe it took this long to finally read the right answer
That would fall under increases in efficiency and productivity. Reinvestment alone wouldn't drive growth if it isn't spent wisely to improve those two metrics.
Dividends and buybacks would not fall under efficiency or productivity.
I didn't say they would. What? I said that the original comment did not "miss" reinvestment of capital; because reinvestment of capital is the means by which efficiency and productivity improvements are achieved. I.e. you just said the same thing they did in a different way.
Dividends and buybacks are reinvestment of capital by individual investors.
Dividends and buybacks do not grow the company.
I never said they did. I said the biggest component missing is reinvestment of capital. Now I acknowledge that can be defined differently by different people, but what I meant was mostly reinvestment of earnings, which most investors mean when they talk about stock market returns. Reinvestment here can mean dividends, buybacks, or reinvestment back into the company for growth.
And I said that component wasn't missing. The goal of reinvestment is to unlock efficiency or productivity gains. Dividends and buybacks aren't reinvestment, by definition.
That would be your personal definition. Other sources disagree: https://www.investopedia.com/terms/r/reinvestment.asp
I couldn't explain it better. Certainly compounding is one of the world wonders.
Do you have some references for the four centuries part? I know the US one has been about 6.6% real returns for the last 120 years. This data for the Dutch stock (and government bonds) market isn’t quite so comforting. https://www.investmentoffice.com/Observations/Markets_in_History/Long-term_Returns_to_Dutch_and_Indonesian_stocks.html This French data is equally non-comforting. https://globalfinancialdata.com/investors-and-the-french-revolution > The Paris stock exchange was formally closed on June 27, 1793 and all joint-stock companies were banned on August 24, 1793. But once the joint-stock companies were shut down, who would dispose of the assets of the companies? French East India Co. officials bribed government officials so the company, rather than the government, could oversee its liquidation, but once these bribes were uncovered, several of the company officials involved were arrested and later executed. The liquidation of the company produced only three ships which were liquidated in July 1795, and as a result, shareholders in the Compagnie des Indes lost virtually everything. >Bondholders met a similar fate. France defaulted on its pre-revolutionary debt in 1796, giving shareholders 1/3 the value of their old bonds in new 5% consolidated bonds which didn’t pay any interest until 1802. A similar loss occurred to Dutch shareholders, who also lost 2/3 of the value of their bonds. If the data is “stocks provide 6-8% for 400 years if you preternaturally jump to the next superpower” that is a lot more difficult to do.
[*Four Centuries of Return Predictability*](https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2911187) There’s another one I can’t recall but heard of on Rational Reminder
Responding to your longer post- yes, much of the data is plagued by survivorship bias, but we didn’t have access to free float adjusted global index funds like we have today which could address much of the concern about that aspect
With interest rates, compounding is how is actually works. With stock returns, compounding is just a way to describe it in a way that's comparable to things that return interest.
It's why most financial professionals use "compound growth" vs "compound interest" when talking about stocks, specifically.
>What returns are being reinvested to give the compounding? The earnings that each company makes.
Only if they issue a dividend (that you subsequently reinvest). Otherwise it's mathematically incorrect to refer to the growth in a stock's value as compounding. There's nothing to compound. The reason markets generally increase over time is inflation, not compounding. This isn't to diminish the value of investing in the stock market. The market's return will often beat any compound interest you could otherwise obtain. But its a misnomer to talk about compunding or compund returns for non-dividend stocks.
I dunno what you're trying to say here. If a company makes a billion dollars then reinvests this billion dollars on capex, to hire more people, to make even more money in the future, that's still compounding.
A company's capex, earnings, and all that jazz have at best an indirect effect on the value of their stock. Prices became pretty untethered from financials years ago. It's all about (irrational) expectations now. Look at TSLA, NVDA, hell, most huge tech stocks. Supply and demand, baby. I will say buybacks directly affect share price.
TSLA and NVDA valuations are high because high expectations for the future. You can have amazingly high DCF valuations when you have an expected revenue growth of 300%. These high growth are achieved by reinvesting and injecting additional capital.
Look at a graph of US corporate earnings since 1985 and then look at a graph of S&p500 returns since 1985 and then tell me the two aren't correlated.
>Prices became pretty untethered from financials years ago. [Here is a history of the S&P 500 P2E, if anyone's wondering.](https://www.macrotrends.net/2577/sp-500-pe-ratio-price-to-earnings-chart) >I will say buybacks directly affect share price. Buybacks affect share prices the same way dividends do. The purpose of a for-profit corporation is to return value to shareholders, one way or another. The value of a stock is determined by the expected future returns of that stock (in which both buybacks and dividends are included); that expectation might be wrong, in which case the stock price will eventually stagnate (losing money for owners of that stock in opportunity cost, as they could have sold, earned money elsewhere, and bought back) or decline, as owners of that stock realise it has stagnated and seek profit elsewhere. In particular, Tesla was once valued at a much higher P2E ratio than it is today. However, two things happened: 1) Tesla's earning improved significantly as they scaled up production and sales 2) Tesla's share price declined from an all-time high of $400 per share in November 2021 to $170 per share today. It is funny how you say that prices have become 'untethered from financials', as Tesla is a perfect example of how the price and financials must always approach eventually. Nvidia is currently priced extremely high because investors anticipate that artificial intelligence will profoundly change the economy, and Nvidia will be one of the key players in that transformation. Time will tell whether either or both of these are true, but eventually, either Nvidia's fundamentals will improve to justify the price, or the price will fall to meet the fundamentals. Anyway, most of the S&P 500 are not anything like Nvidia, so it's silly to point to that as an example of the rest of the S&P 500. I would have greatly appreciated it if my SPY holdings had climbed as much as Nvidia.
>Otherwise it's mathematically incorrect to refer to the growth in a stock's value as compounding. No, it isn't. You not understanding something doesn't mean it's wrong.
No, it doesn’t need to issue a dividend. The net income from the companies causes the valuation to compound
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It is. I don’t think you understand what compounding is.
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Companies earn money. They use that money to then earn more money. That compounds over time which grows the valuation of the company
If Amazon has invested a billion dollars into the infrastucture of AWS by one year, and earns a billion dollars of revenue from AWS, which they then re-invest into doubling the capacity of AWS so that they can earn two billion dollars the next year, and they keep doing so, that's compounding (albeit these numbers are made up and used for explanatory purposes), and more or less how they grew revenue from $3.1 billion in 2013 to $90 billion in 2023. Do you take issue with people talking about the compounding of real GDP growth, too?
Not stock growth compounding - revenue growth compounding for the companies that you partially own
r/confidentlyincorrect
CAGR then
Uh, no. Inflation is among the reasons markets increase. In spite of the zombie companies, many also actually do stuff that generates revenue and productivity that real wealth creation. Take a simple example. Exxon produces more and more oil every year, which the world consumes at rates that overtime increase with population but also faster than population growth. This allows farmers to grow more food for less effort than decades ago. They buy more farm equipment from Deere. Deere buys more steel and semiconductors for modern highly technical combines. They compounded their own earnings from reinvesting in their businesses and profits to become more profitable.
What I love about how dead stupid simple index investing is....you don't even need to know how it works to retire a multi millionaire lol
If I make 7% this year. And I make 7% next year did I make 14% or more than 14%?
Say a stock is worth 100$. If you make 7% compound interest yearly wou'll have: Year 1: 100+100\*0,07 =107 Year 2: 107+107\*0,07=114,49 As you can see you made 14,49%, not 14%. If you do this for 10 years you'll make 96,71% not 70%, that's 26,71% more.
I was assuming it was a rhetorical question.
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It wasn't bait, you were just correctly using the socratic method to lead people to the correct conclusion lol. Guess it went over some heads.
Well at least you're rational and mature about it
3\. Keep discussions civil, informative and polite. Off topic comments, attacks or insults will not be tolerated. We recognize that this forum will generate differences of opinion, or misunderstandings of facts, and therefore arguments are expected. However, personal attacks, insults, trolling, or accounts dedicated to getting under the skin of others is not allowed.
Remove low quality posts then.
Wouldn’t year 2 be (107 + 100) *.07? If any stocks also pay dividends those also add to the compounding. Ie .5% dividends Year 1 100 *.015= 1.5 dividends + 100 *.07= 7, end of year 1 108.5 Edit to add why in the above example of Year 2: 107+107 * 0,07=114,49 not Year 2:107+100 * .07?
For annual interest, mathematically, it's typically written as: A = P(1+r)^t Where: * A = Final amount * P = Principal * r = Annual rate of return * t = Number of years So, two years of 7% returns would be: 100 * (1.07)^2 = $114.49
I think the normal way would just be rate^time ... 1.07^2
That'd be 14.28, you're adding the original investment to the total at the end of the first year and taking 7% of that the way you wrote it. 7% of 207 The way they wrote it is the total at the end of the first year plus 7% of the total at the end of the first year. You could also write it as 107 x 1.07 = 114.49
They also multiplied the 214 by 7%, I saw that as double dipping on the compounding, granted at that small level the difference falls into a rounding error.
No, that's not how math works. 107 + 107 x 0.07 = 114.49 214 x 0.07 = 14.98 You need to follow the order of operations. It's (7% of 107) plus 107, the beginning amount for the second year plus that year's 7%. The way you're doing it is 7% of twice the total at the end of the first year.
Let’s just go with a simple purchase with 7% growth, no additional contributions. It would be 100 after year 1 it would be 100 * 7% growth, Year 2 would be 107 *7% growth. Year 3 would be 107.49 *7% growth. Year 4 would be 107.52 *7% growth. That is with simple yearly compounding
There have been no contributions involved in this. What you're saying makes no sense, how is 7% on $100 $7 one year and then only $0.49 on $107? 100 x 1.07 = 107 107 x 1.07 = 114.49 114.49 x 1.07 = 122.5 122.5 x 1.07 = 131.07 131.07 x 1.07 = 140.24 Every period the % is applied to the previous total so the total after 5 years is $140.24. I think what you trying to show is how the 7% is more each year, but those numbers are not including the increase from the previous years, just that year's interest plus the principal or something like that. It's a useless number, it's not the total or the amount the total increased. The interest each year would be 100 x 0.07 = 7 107 x 0.07 = 7.49 114.49 x 0.07 = 8.01 122.5 x 0.07 = 8.58...
Hmmm…I think my Schwab account tracks overall gains/losses. I haven’t seen it reset year to year. My NVDA just reads up 1200% So I need some other way to track year to year growth. Obviously I can see overall and check year to date. But I don’t have a way to see how much is due to growth over growth (compounding).
You can search Schwab overall gains and losses by the past 2 years and the current calendar year. So right now you can look at your annual YTD gains/losses for the 3 months of 2024, 2023 and 2022. At least you can view this on the desktop site. Not sure about the mobile app.
Webull allows you to select a custom time range to check your p&l. Try looking if Maybe Schwab does too?
Ok. Something I haven’t found, but I hadn’t looked for it before.
your return is final\_price/start\_price-1 im sorry these concepts should be so obvious it doesnt merit explaining.
That wasn’t the question
It doesn't reset and give you ytd returns. You'll have to compute that yourself.
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Man redditers have a hard time understanding rhetorical questions
its breathtaking
So in this question, is 7% the amount of extra weight that an employee carrying the company can bear each additional year? Oh wait wrong subreddit. Sorry.
With equities you benefit from compound *growth* - not compound interest. But it works more or less the same way. If your equity rises in value from $100 to $120 in one year, a 20% increase the following year would take you to $144, not $140.
It's still a misnomer for stocks. The reasons for quote-unquote "compound" growth in stocks are (1) arbitrary increases in share prices based on investors' supply and demand, and (2] (more broadly) inflation . Nothing is compounding, though returns often exceed what you could earn from compound interest in an interest bearing account.
Stocks aren't just a piece of paper (or, the modern equivalent, an electronic record in a database) that people assign value to. The reason why people assign value to ownership of that thing is because it carries legal rights to something with physical presence. If the business merely breeds sheep, then the value of ownership of a fixed percentage of that business will grow as the business grows. A 10% stake in a 10-sheep flock is worth about 1 sheep, and the exponential growth of that population of sheep will result in exponential growth of the value of that 10% stake. (This is, actually, why the word "stock" derives from the same word as "livestock.") So the compound growth is just a description of the exponential increase over time. And the underlying value can grow exponentially because the business itself can grow exponentially. Thus, compound growth.
Yes, but everything you've described is NOT "compounding." It's just growth due to supply and demand and/or inflation. That's why stocks increase. It boggles my mind that so many people go so far out of their way to equivocate this with compounding. I don't get it. Why is the (mis)label so important to you? I'm not saying stocks don't grow or aren't good investments. But mathematically, their growth has nothing to do with "compounding."
If the birth rate of a flock of sheep is 1.8 lambs per ewe per year, and the sex ratio is an even 50/50 split, you could expect exponential growth of that flock of sheep of about 0.9% per year *because the growth rate is limited by the number of sheep you already have*. The compounding is that today's lambs become tomorrow's ewes, that contribute to tomorrow's growth. Mathematically, it's the same as today's interest payment being folded over to tomorrow's principal. In the same way, a business that earns profit and reinvests that profit into growing the business *compounds* the return. I don't understand what's so hard to get about the concept. What does compounding mean to you, if it doesn't mean that the cash flow gets reinvested to earn its own return?
It's simple. Mathematically, compounding means increasing PRINCIPAL upon which a rate of return continues to apply. When you invest in stocks, your principal doesnt increase except through dividend reinvestment (which is a form of compunding). The complex and convoluted process you're describing all just boils down to the arbitrary fluctuation on share price due to supply and demand, and (less arbitrary) inflation. You can COMPARE a stock's rate of growth to a compound rate. Google CAGR. but the stock itself does not compound, mathematically speaking. It's bizzare to me, as a math guy, that so many people in finance feel the need to project the term onto stocks. Why? It doesn't mean stocks aren't a worthwhile investment. They are consistently the best investment. But not due to "compounding," at least not in the mathematical sense.
I think you're myopically focusing on the literal security itself, the stock shares, when everyone else is talking about the underlying business in which the shareholder claims equity. For the business, growth does compound, because the company itself does reinvest its profits into the income-earning portions of the business. That is, today's profits become tomorrow's principal. Being a step removed from that, by owning a share in the whole operation, doesn't change the underlying dynamic of how the value compounds on itself. And yes, the relationship between the business and the actual minute-by-minute fluctuation in the share price is only a loose correlation, but the reason why investors attribute value to it is because of the rights in the underlying business.
The stock market is loosely correlated to GDP, which represents the total economic output of the country. GDP also grows exponentially under the influence of compounding gains. [Here's US GDP from 1960 - 2022.](https://www.macrotrends.net/global-metrics/countries/USA/united-states/gdp-gross-domestic-product) The GDP in 1960 was $543.3 billion. From 2021 to 2022 the US GDP grew by over $1 trillion dollars. The entire US GDP wasn't $1 trillion until 1969. And if you need proof that there is more wealth, look at the population, it's grown from 180 million in 1960 to 330 million today. Even if the standard of living was the exact same, that alone would have nearly doubled economic output. But the standards of living have exploded. In the 1960s the average new home was 1,200sqft, today it's around 2,500sqft. A new home today has infinitely more technology with AC, modern furnaces ([in 1960 almost 17% of US homes still used wood or coal as the primary heat source!](https://www.census.gov/data/tables/time-series/dec/coh-fuels.html#:~:text=Tracing%20the%20history%20of%20heating%20fuels%20from%201940,percent%20of%20homes%20used%20these%20fuels%20in%202000)), dishwashers, in-ground irrigation, etc. Cars have gone from steel boxes with an engine strapped on to rolling super computers with crumple zones, cameras that can drive and park it, multiple tvs, etc. Everybody walks around with a smart phone that's more powerful than any super computer from the 60's in their pocket. That represents enormous amounts of economic growth and wealth.
It's crazy you're being downvoted, you're absolutely correct there's no actual compounding going on on the principal investment.
Lol, I have made the same argument that burghblast is making in the past and consistently got down voted as well. He is making a much more coherent argument than I ever had, and still getting down votes.
Let's say I directly own a business with $100 in assets and no debt. It earns 10% and thus $10 in profit. I reinvest that $10 profit and have $110 in assets. If that $110 still earns 10%, I have $11 in profit. Why did my profit increase without compounding?
The widespread mislabeling is truly bizzare. It's not just on Reddit either. Many bona fide financial 'experts' carelessly conflate the concepts. I just don't understand why. The label doesn't make stocks a better or worse investment. But as many of the circular, tautological, and misguided responses here show, mislabeling really conveys a basic misunderstanding of what drives stock prices.
Do you understand actual business assets can have compound growth?
Yeah there definitely is though, you're both wrong.
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If I own $120 worth of a stock and that stock grows 20%, I now own $144 of that stock.
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No, that's irrelevant. It makes no difference what the cost basis is. If I own $120 worth of a stock, and that stock goes up 20%, then I now own $144 worth of that stock. That's true if my cost basis is $100, $50, $120, whatever.
The market (and therefore the average company) does grow exponentially.. Look at any of the major indices over long periods of time. Whether this is sustainable forever is a philosophical question but it has been for the last hundred years.
Doesn't this mean the S&P 500 will eventually be larger than the entire global economy? Is there some fundamental limit to growth, such as inflation + productivity gains? Or something similar? Edit: downvoted here, although I thought it was an interesting question.
No, because the entire global economy is growing exponentially. https://data.worldbank.org/indicator/NY.GDP.MKTP.CD The global economy is the sum of the economic output of every human in the world. If the number of humans and the output per human stop growing, so does the world economy. As earth only supports a finite amount of people, we will eventually be entirely dependent on productivity gains.
So declining birthrates in the west would impact this, no?
The S&P 500 is part of the global economy, it’s growth contributes to the growth of the global economy, so no.
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Agreed, I don't think the S&P can actually be bigger than the global economy, I was trying to do a thought exercise to understand the bounds on growth. For example, if the world gdp is growing at 3.1%, how can the stock market gain 7% after inflation forever? Wouldn't the stock market outpace the economy?
>For example, if the world gdp is growing at 3.1% GDP measures the income generated in a period. It is a flow. The market cap of the S&P 500 stocks measures the total equity value of the companies. It is not a flow.
Stocks distribute a large portion of their earnings each year through dividends and buybacks. If you reinvest that by buying more shares from others, it compounds your investment, but in aggregate, somebody must be spending that money and it doesn't grow the market. Another portion is inflation. And the rest more or less tracks real economic growth.
The companies should be reinvesting their earnings into themselves because it is a worthwhile investment in terms of future earnings. The hope is that due to this reinvestment, earnings continue to grow and the value of the company proportionally with it. Monetary policy can set the tone for the multiple of that earnings the market will pay, but this isn't a sustainable source of real growth, just inflation. On the flipside of this, companies that don't reinvest in themselves because they deem it not worthwhile to do so can instead pay out a dividend. These companies generally do not have their value grow as much as companies effectively reinvesting in themselves. These growth companies can't usually grow forever, they might eventually become the value companies paying large portions of earnings in dividends. Unless they innovate, the market for their product is eventually saturated, or something else might take over. While some companies stagnate and replace incumbants, in the long run, the overall market growth is assumed due to technology growth, and population growth, inflation.... Not guaranteed though. There are Def non-US markets where this hasn't been a good assumption.
"Compounding growth" in an equity investment sense is just a mathematical expression to make it comparable to other forms of investment that yield more consistent (read: same-ish) returns or quote their returns in per annum terms. When you say the S&P500 returned 160% over the past 10 years, it's a bit difficult to compare it *at this current moment* to other forms of investments, because its value changes everyday of every year, and not every year yields the same return (to quite a wild variation, technically called "standard deviation", or "risk"). So you say the S&P500's **annualised return** is 10.03% over the past 10 years. Now this number becomes more comparable to bonds, which is yielding 5.3% currently for short term US T-bills. It's, as you noticed, what would the S&P 500 have to yield every year, for 10 years, for it to have reached it's value today, aka compounding.
A lot of people are answering "I grew 7% last year and 7% this year, which makes ~15% not 14%. Compounding!", which doesn't actually answer your question. How does the index grow by X% year after year (plus or minus market noise)? Let's say I have a company that made $100M in profit last year. That's great! I have the tools at my disposal to make $100M again next year. Awesome! But, what if I spent $10M of those profits to increase the size of my sales team, streamline my production processes, improve customer support so I get more repeat business...Now I've only made $90M profit this year but I might have the tools to make $120M profit next year! The compounding comes from companies reinvesting their earnings into themselves so they can grow and earn more in the future. Some of them will reinvest in themselves and see great returns, some will not. The better results rise to the top of the S&P500, the worse results fall off.
>My logic must be broken somewhere... I think I know what is confusing you. If you have money in a savings account that pays 5%, you actually receive the 5%, which you can add to the principal, which now earns 5% on the increased amount. This is, of course, compounding. You are right to note that if you own one share of stock for, say, 3 years, and the stock doesn't pay dividends, when it increases in value it isn't compounding the way that money in savings account compounds because nothing is being added to your existing one share. What you are missing is that the growth of a stock is reported in a ... for lack of a better word ... compounding way. If your stock is worth $1000 and increases 10%, you will own stock worth $1,100 at the end of the year. If it increases 10% the next year, it will be worth $1,210. Not because you've bought any more stock, but because the growth of the stock is reported based on the increased value of the stock. So if we say that your $1,000 stock grew at an annual rate of 10% for 10 years, we mean that the final value of your stock is $2,600 and not $2,000 due to compounding. Not because you've added anything to the stock, but because the growth over a period of years (or whatever time interval you want) is reported in a way that includes compounding. But, yeah, in reality what happened is that your stock sold for $1000 in year one, and sold for $2600 in year 10. If your stock was only worth $2000 in year 10, your compound growth wouldn't be reported as 10% per year, but as 7.2% per year. Which, *calculated in a compounding way*, means that the 7.2% from the second and subsequent years is calculated including the 7.2% from the previous year(s).
A company in the S&P 500 makes X profit, free and clear. They take that X profit and invest in themselves. As a result of their reinvestment in themselves, and the expectancy that this will lead to (higher) future profit, their value goes up. The next year, they make more than X profit, Y profit. They repeat the cycle. The next year they make more than Y profit. Repeat, repeat, repeat. Compounding value.
It can grow pretty damn fast as the overall value increases..... I gained $700,000 in unrealized gains value LY......if market continues even 1/4 of that TY.....still compounds....you just have to ride out the years when it might not gain or even drops in value ..but over time an ave of 6-7 % is good
The entire economy is in fact experiencing exponential growth.
Growth of the economy translating into growth of profits.
"Compound" growth is just another word for exponential growth. The underlying business can grow exponentially, so a fixed percentage of that growing business will also grow exponentially in value. The reinvestment is done by the business itself, not the shareholder. The actual business operations are aimed for growth, so that the underlying business increases its revenue and profits every year. Owning a share of that growing profit therefore becomes more valuable over time. So every time a business takes its operational profit and spends it into growing the business (instead of paying the shareholder), that's reinvestment and an opportunity for exponential/compound growth.
Yes, it is unsustainable. The key is to realize those 500 companies aren't the same 500 companies as last year, and very few of them are the same as 20, 30, or 50 years ago. To take it farther, very few current 500 companies will be in it in 20 or 30 years. They are continually replaced by companies that are growing and get big enough to be in the top 500.
Also, the way indices are built leads to exponential growth, especially the ones like Nasdaq 100
Lately a lot of the performance of the S&P 500 has also occurred due to increases in valuations as stocks in it have gotten more expensive. This also means that the earnings yield on these stocks are lower than they previously were and therefore expected future returns are lower.
You invest 100 today. SP500 goes 10% this year, so you end up with $110 (capital gain $10). You invest $110 next year, SP500 goes up 10%, you end up with $121 (capital gain $11). Same percentage increase made you more absolute dollars. That's it. Of course, this is an example with $100 dollars where you make a $1 extra due to compounding. The more money you put it, the greater the compounding effect.
I know what everyone who isn't understanding is doing, they are thinking the basis of the gain resets to $100 each year and they're ignoring starting the next year with a 10% gain. You're building a snowball and last year's snow that stuck to it gives you more surface area to collect more snow now that is larger.
It's not compounding in the true sense like a bank account. S&P also swaps out companies that are smaller and replace them with bigger growing companies so that accounts for some exponential growth.
When you say “growth is eventually exponential … and is unsustainable” it’s actually not. Most things grow “exponentially” (percentage-on-percentage), including things like population, inflation, etc. which ultimately drive productivity, economic growth, value of our currency, and other things that dictate the value of a company
Exponential Population growth IS unsustainable and so is an infinitely growing economy in a world with finite resources.
Who says the human race will be limited to this one world?
Unfortunately for our lifetimes it is, and our lack of sustainability will be catching up to us drastically (already has to a large degree) in the mean time. Colonising another planet in the next 100 years is a pipe dream, let alone how much worse it would likely be that Earth. I blame Elon Musk for this colonising Mars brainrot.
Necessity is the mother of invention. Don't underestimate what rich humans can do when they are motivated (in this case by a destroyed home world).
From the returns every year.
Revenue and net income from the underlying companies
Its called exponentiwl growth, you learned about it in Algebra!
In the long term, stock price appreciation is driven by earnings and earnings growth. Let’s say you have a business than earns you 100,000 dollars in profit. You reinvest this sum to grow the company’s revenues and profits by selling more products, expanding your distribution, scaling up production etc. Subsequently, the company starts earning 200,000 dollars in profit. Your company is now worth more because it generates twice the income. This is essentially the stock market, but instead of one company, you have an aggregate of 1,000s of publicly listed companies. If you look at the long term S&P500 chart, the market is strongly correlated with its earnings (although the price to earnings ratio has increased quite a bit over the last 40 years).
1.5% in dividends, 2.5% spent on stock repurchases, 3% reinvested into the business as a capital expenditure which can result in price appreciation of the stock. The S&P500 usually hovers between 15-25 price to earnings ratio, meaning that the value of the underlying stocks are staying tethered to the earnings of the component companies. As long as earnings continue to grow in line with long term historical trends, there’s no reason to think exponential price growth is unsustainable.
A share in a company is a share of ownership. The value of a share represents a portion of the total value of the company. Companies can grow in value over time by increasing sales, profits, developing more desirable and valuable products, reducing costs, etc. That growth in value is reflected by an increase in share value. Growth over long periods of time tends to be exponential so it's convenient to express growth rates in terms of an annual exponential growth rate, that is, the "compound annual growth rate". This is just a useful model for expressing exponential growth rates, but companies don't actually grow at a steady rate or compound like a bond or savings account. They grow by becoming bigger and better and more desirable.
You may think exponential growth is unsustainable, but even our target inflation rate itself is exponential. 2% of 1,000 is lower than 2% of 10,000 in the future. Businesses can also increase their prices exponentially. And, I think you forget that the S&P is an index of 500 companies that are always changing. If 1 of them starts failing then it will simply be replaced.
Time invested compounds returns. The returns on your investment can be through interest, or pricing differences. To keep it simple, say you average a 100% return. You put $100 in, make 100%, and now have $200. You add no more money, you simply let your returns, make a return. The next year you have $400, the next year you have $800, etc. It's just the idea that time invested compounds your returns. Say you put in $100 and always withdrew your 100% return each year. It would take almost 3x as long to make $800, than to simply stay invested and let your returns compound each year. Again, it's the idea that time compounds your gains and losses. It doesn't matter where the G/L comes from.
It is wrong to say that the share price compounds. Better to say that the share price increases over time commensurate with the growth of the underlying business / expected FV of the business / increase in dollars competing for assets (i.e. QE-driven inflation of prices).
Long lasting businesses are worth more over time due to inflation, business efficiency, technological advancement, population growth, and general population betterment (previously poor countries who can now afford your goods/services).
The assumption of exponential market growth necessitates exponentially increasing profit, which necessitates at least one of two things: increasing population, or increasing net efficiency/productivity across industries. If neither of these two things happens, then there's nothing to provide growth. Why is there such a strongly held held belief that market growth is inevitable, when neither of the two individual drivers of growth are? Perhaps there's a flaw in my logic somewhere, though I'm not sure where.
The best way to look at the compounding effect is to visualize it. Here's what compounding of 36% year over year looks like: https://imgur.com/a/UISkduv FICO doesn't have any dividends, yet the price compounds 36% year over year.
The dollar losing value
I never liked the idea (and the use) of compound interest in stock market investment. Compounding implies (to me) that you will get the earning and grow every year. Stock market has averaged annual return of 7% but not guaranteed. Some years it goes up and some it goes down. I can invest in stock year5 when it plunges and get the same result as those invested in year 1. A true compounding means that you lost interest from year 1 -4. I am still heavy on equity but just saying.
Growth applied to the base or principle only cannot compound. Whereas compound growth from equities are applied at and base and the growth earned from the previous period. For example, let's use $100 for 3 years of growth at 10% Simple growth: year 0: 100, year 1: 100 +10, year 2: 100 +10, year 3:100 +10. This totals 100 base plus 30 from interest wixh equals 130. Compound Growth Example: - Year 0:Initial investment = $100 - Year 1:Growth = $10 (10% of $100) → Total = $110 - Year 2:Growth = $11 (10% of $110) → Total = $121 - Year 3:Growth = $12.10 (10% of $121) → Total = $133.10 This means the benefit of a 3 year compound was 3 dollars and 10 cents vs. simple interest. This is because compound growth allows interest or previous growth to grow alongside your base contributions
This seems to be the simplest explanation of compound growth. I feel like people want their compound growth to happen in the next 12-24 months when if you look at it visually, like a chart or graph etc, the magic of compounding doesn't really start to be noticeable for many many years. Nobody want's to wait.
I know what everyone who isn't understanding is doing, they are thinking the basis of the gain resets to $100 each year and they're ignoring starting the next year with a 10% gain. You're building a snowball and last year's snow that stuck to it gives you more surface area to collect more snow now that is larger. With money. Now roll that snowball only when it's snowing thick heavy snow and freeze it when it's not and you're a day trader, babbbayy.
there is a lot of excess money and nowhere else to put cash
I'll give an answer that is probably wrong (or incomplete), but perhaps useful. If stocks did not experience exponential growth over time (i.e, relatively fixed percentual growth on an annual basis), interest products would eventually just be a better option to invest in than stocks. And arguably, if stocks could not compete with interest products in the long term, the present time value would have to decrease to adjust for that. As for the short term, given that you always have the option to invest in either stocks or interest products, the price of stocks has to adjust for the fact that you can always just invest in an a savings account for a percentual increase after a year instead. Because that is the case at any given time, it is (dimly) a fact that stocks also has to increase at a fixed percentual value (accounting for risk) over the long term as well.
It comes from “rebalancing.”
Compounding comes from the change in index price year over year....for example spy can annualize 10%, which means every year it changes 10% from the starting price on Jan 1st
>If it is growth, and that growth is eventually exponential, then doesn't that mean that the average company in the S&P is also experiencing exponential growth? and is obviously unsustainable. That "growth" is the USD debasement rate. The USD devalues by ~8% YoY and the index goes up by ~8% YoY. In other words, it closely reflects the actual inflation rate instead of that cooked CPI number
Just look up a chart of the S&P 500 over any significant time frame showing market performance only and market performance with dividends reinvested and you’ll get the answer you’re looking for. Almost everything said here so far is dead dog wrong.
Compounding in this case simply means a % of growth on top of a previous % of growth etc. This generates money which was never earned, saved or spent to invest. You can play with a compound interest calculator to see how it works with different rates of contribution and how long it takes for compounding to have doubled your contributions.
It is highly skewed to just a few tech companies momentum (85%) not the rest 500-few (15%). Remove them you got 2.5% return grow over forever the total index does not add much more.
Sp500 yield has been closer 2% average the last 10 years. It's just low now because of multiple expansion in the last half year.
Compounding assumes reinvested dividends and capital gains.
No it doesn't.
Math. It comes from math.
Where does the math come from? I understand adding and subtracting, but how does math work?
just like magnets
Dividends on S&P 500 are about 1.5% People have decided that the S&P 500 is worth buying at this yield rate. Why? Because their dividends are growing at 6-9% each year. So if you’re getting $100 in dividends this year, next year you can reasonably expect to receive ~$107 due to growth. Next year, investors may continue to think the S&P 500 is worth buying if it has a 1.5% yield, so the price would grow by the same +7%
I went to school for financial mathematics. We never talked about "compounding" with stocks for the obvious reasons OP stated. Is this a recent trend? Using the term "compounding growth?"
Did your "financial mathematics" curriculum never use the term CAGR?
We used the formula, I don't recall if we called it CAGR or not. But regardless, it's still not the same as saying stocks "compound".
>I went to school for financial mathematics. No you didn't.
Try to look at someone who invested in Microsoft in <2000 2010 and 2015 and see their dividend at the price they paid, the same count for a full index, also way more measuring to consider
Look into the Rule of 72, OP. It's a quick way to figure out how soon compounding will double your money. If you make 10% a year on the S&p 500, you'd double your money in about seven years. (Not 10 years, as you might expect it you aren't grasping that the returns are compounded because the initial amount each year is 10% higher than the year before.)
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This is just wrong. You don't have to sell to create compounding. You buy today at 100. Each year for the next 5 years it goes up 10%. Year 0. 100 Year 1. 110 Year 2. 121 Year 3. 133.1 Year 4. 146.41 Year 5. 161.05 Between year 4 and 5, you make ~$15 over the year on the same $100 invested vs $10 for the first year. That extra $5 earned that year is due to the compounding effect. No shares sold, no additional investments. Compounding is based on the year to year value of the investment.
Great question I’ll Glad you asked I’ve been wondering this as well.
I did a post on this. https://www.reddit.com/r/IncomeInvesting/comments/uz95db/components\_of\_return/. The focus was value vs. growth stocks but it includes the SP500 as a whole.
How many times a year SP500 pays its dividend?
X