Compound interest can be a saver’s best friend, and it’s also a valuable tool for investors. In simple terms, it means the interest you earn on your interest. But how does compound interest work with stocks, mutual funds, or other securities? Understanding what it means to earn compound interest on investments is key to developing a wealth building strategy.
A financial advisor can guide you through different compound interest options for your savings needs and goals.
What is compound interest?
Compound interest is the interest on your interest. Specifically, it is interest earned on principal and interest that accrues over time.
Here is a simple example of how compound interest works. Let’s say you deposit $10,000 into a savings account that has an APY of 2%. At the end of one year, you would have $10,202, assuming interest accrues daily. After two years this amount would increase to $10,408 and after 10 years you would have $12,213.
You do not make any additional deposits to the account. But because you earn interest on your principal and interest through compounding, your money keeps growing.
This is the main advantage of compound interest and why it is better than simple interest. With simple interest, you only earn interest on the principal deposit. Over time, compound interest can be much more powerful in building wealth.
How does compound interest work with stocks?
Investing in stocks can help you earn compound interest at a potentially higher rate and over a longer period of time. Although they carry higher risk, stocks can offer greater returns. Instead of earning 2% on a high-yield savings account, you could be earning a 10% or even 15% annual rate of return on stocks.
As for how compound interest works with stocks, it follows the same rules as compound interest for savings accounts. Your rate of return may depend on:
how much you invest
The more time you have in the market, the more time you have to take advantage of compound interest. Here are some examples of how compound interest on stocks works, using different investment periods.
Example 1: Investment over 12 months
Suppose you have $10,000 to invest. You want to buy 100 XYZ shares, worth $100 each. You plan to hold these shares for one year and expect an annual rate of return of 7%.
After a year, you would have $10,700. But what if you bought $500 worth of additional stock each month? Now you would end up with $16,700 instead.
Example 2: Investment over 5 years
Now suppose you buy $10,000 of the same stock and earn an annual rate of return of 7% for the next five years. At the end of this period, you would have $14,025.52, of which $4,025.52 represents compound interest earned.
That total grows to $48,529.95 if you buy an additional $500 worth of stock every month during that five-year period. Of this amount, $8,529.95 represents compound interest earned.
Example 3: Investment over 30 years
How much money could you end up investing in the same stock for 30 years? If you were to buy $10,000 worth of stock and make no further deposits, you would have $76,122.55 after three decades.
Again, that’s at a 7% annual rate of return. If you were to invest $500 more per month in the same stocks, your money would grow to $642,887.27 over a 30-year period.
These examples all assume that interest is compounded annually. It’s important to note that interest can accrue at different frequencies, including daily, monthly, and quarterly, depending on where you keep your money. You can use an investment calculator to run different return scenarios.
The fact, however, is that compounding can be a good thing from an investment perspective. Even if you make a one-time stock purchase and never buy another stock, you could still end up with more money than you started with thanks to compounding. This assumes, of course, that the stock continues to generate a positive annual return for each year you own it.
How to make compound interest work for you
Using compound interest to your advantage as an investor is not that difficult. The first step is simply to start investing.
Waiting to start investing could cost you dearly if you miss out on valuable compound interest. Suppose, for example, that you want to start investing for your retirement. You open a Roth IRA and invest $6,000 a year in exchange-traded funds that hold a mix of different stocks.
If you start saving at age 35 and earn an annual rate of return of 7%, you’ll have $498,172 by age 65. What if you started investing at age 25 instead? In this case, you would end up with $971,544 instead, almost doubling your money. This example shows how important the time factor can be when taking advantage of compound interest.
In addition to starting early, you can also make compound interest work for you by being consistent with your investments and choosing the right stocks. The obvious goal is to select stocks that are likely to increase in value over time. This is at the heart of a buy-and-hold strategy.
Researching different stocks can help you choose the best ones for your portfolio, based on your investment style and risk tolerance. Value stocks, for example, may be appropriate if you are looking for stocks that are undervalued by the market and likely to appreciate over time. You can also benefit from the current income of these shares in the form of dividends.
Opening an online brokerage account can be a simple way to start investing in stocks. Depending on the brokerage firm, you may be able to trade individual stocks and ETFs commission-free. You may also have the option of investing in mutual funds, bonds, IPOs, options, forex, or cryptocurrency.
If you’re not sure where to start with stocks, talking to a financial advisor can help. An advisor can break down the basics of how stocks work and how to create a diversified portfolio. They can also offer advice on how to take advantage of tax-efficient accounts, such as 401(k) or IRA, as part of your investment plan.
Compound interest is one of the simplest investment concepts, but its importance is often overlooked. If you are not yet investing in stocks, you may be missing out on a chance to benefit from this concept. Even if you can only afford to invest small amounts to begin with, you can still see gains over time through compound interest.
Consider talking to your financial advisor about different stock buying strategies and how to use them to achieve your financial goals. SmartAsset’s free tool connects you with up to three financial advisors who serve your area, and you can interview your matching advisors for free to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, start now.
If you want to take advantage of compound interest, it helps to understand the principle of cost averaging. With cost averaging, you are continually investing money, no matter what is happening in the market. The idea is that by doing so, you can smooth out variations in stock returns caused by increases or decreases in volatility. This is different from average value, which dictates investing more or less money over time, depending on the current value of your investments. Again, these are things your advisor can help you better understand as you implement your investment strategy.
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How does compound interest work with stocks? appeared first on SmartAsset Blog.