Compounded Interest on Mutual Funds

Question

I may be missing or misunderstanding something regarding how compound interest works with mutual funds and ETFs.

Let's say I have $10,000, and I invest said monies in mutual fund XXXXX at $100/share, effectively giving me 100 shares. Now, let's assume at the end of the year I have a 5% return. My $10,000 is now $10,500.

At what point does my investment benefit from compounded interest? Monthly? Quarter? Yearly? Does it even benefit?

I'd love a clear cut example that brings in market fluctuations YOY (let's say my investment loses money the following year).

I may not even be asking the right question - I'm very new to this stuff and am trying to understand how a long-term play into purchasing diversified mutual funds grows over time and how compounded interest affects my invested balance.

I haven't found an explanation or calculator that I can wrap my head around.

Thank you for any and all assistance. I will continue searching the web while I wait for a reply.

EDIT I think this post cleared it up for me a bit.

It's the reinvestment of the dividends that are paid out from the fund that grows my investment - the dividend is the compounded part. Right?

Answer 1

Let's say I have $10,000, and I invest said monies in mutual fund XXXXX at $100/share, effectively giving me 100 shares. Now, let's assume at the end of the year I have a 5% return. My $10,000 is now $10,500.

At what point does my investment benefit from compounded interest? Monthly? Quarter? Yearly? Does it even benefit?

Daily would be my answer as your investment, unless you are selling shares or not re-investing distributions is getting the following day's change that impacts the overall return. Consider how if your fund went up 2% one day and then 2% another day from that $10,000 initial investment. The first gain brings it up to $10,200 and then the second makes it $10,402 where the extra $2 is from the compounding. The key though is that these are generally small movements that have to be multiplied together. Note also that if your fund goes up and down, you may end up down overall given how the returns compound. Consider that your $10,000 goes up 10% to $11,000 and then down 10% to result in $9,900 as the return for up x% and down x% is (1+x)(1-x)=1-x^2 which in this case is 1% as 10% of 10% is 1%. The key is how long do you keep all the money in there so that the next day is applied to that amount rather than resetting back to the initial investment.

Answer 2

At what point does my investment benefit from compounded interest? Monthly? Quarter? Yearly? Does it even benefit?

I think you are mixing things. There is no concept of interest or compounding in Mutual Funds.

When you buy a mutual fund, it either appreciates in value or depreciates in value; both can happen depending on the time period you compare.

Now, let's assume at the end of the year I have a 5% return. My $10,000 is now $10,500.

The way you need to look at this is Given you started with $10,000 and its now $10,500 the return is 5%. Now if you want to calculate simple return or compounded return, you would have to calculate accordingly. You may potentially want to find a compounded return for ease of comparison with say a Bank FD interest rate or some other reason.

So if $10,000 become $10,500 after one year and $11,000 after 2 year. The absolute return is 10%, the simple yearly return is 5%. Or the Simple rate of return for first year is 5% and for second year is 4.9%. Or the Average Year on Year return is 4.775%.