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I was wondering if someone could explain the concept behind compounding your stock investments. For example, let's say I buy 10 shares of a stock at 10 dollars each for a total of 100 dollars. That same stock price the next day goes to 12.00 dollars per share. You've made a 20 dollar profit. If the stock drops the next day to 5 dollars, withdraw your profit of 20 dollars and then use it buy back into that same stock, but now 5 dollars a share. You have just reinvested/spent your profit of 20 dollars to buy five more shares of this stock at 5 dollars per share. Someone had explained this concept to me, and I want to make sure I understand it correctly. Have I interpreted this correctly, and is it a solid concept?

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    If that's how stocks worked then the global economy would be in serious trouble or non-existent in the first place. – MonkeyZeus Feb 26 at 13:58
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    Generally when I hear people talking about that they're referring to re-investing stock dividends. – Jared Smith Feb 26 at 14:11
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    You can think of stock as analogous to some physical thing. It's not quite the same, but it can work to help understand this. Replace the word "shares" with "shirts" (or "used iPhones" or "gold") and try to make sense of it from there (assuming you can buy and sell shirts for the same price). If you have 10 shirts and the price of shirts increases, you'd still have 10 shirts. You'd need to sell them before you make any profit. There are also dividends, which would be comparable to being sent money for each shirt you own. – NotThatGuy Feb 26 at 17:42
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    @NotThatGuy The dividend part of your analogy doesn't really work. It's more like, the shirt can shrink or grow in size (value) over time, and you can be given little torn off pieces of the shirt (dividends) but doing so will reduce the size (value) of the shirt. The important part to grasp is that dividends aren't "free" money, they come out of the company's distributable profits, and the fact that they have been paid to the shareholders means the company has less assets and is thus worth less money. – JBentley Feb 27 at 2:41
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    Don't forget the fees. – Mast Feb 28 at 10:44
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No, you've misinterpreted it.

When the stock drops to $5, your 10 shares are now worth $50. You have lost $50. The $20 profit you had on the previous day was a potential profit (called paper profit, or unrealized gain), based on selling at the $12 price, and you didn't take that offer.

If you had sold at $12, and kept the $120 as cash (ignoring commissions and taxes for this example) you could then have bought 24 shares at $5.

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    Good answer which precisely outlines the cause of the OP's confusion, rather than focusing on the exact terms used. – Grade 'Eh' Bacon Feb 25 at 20:46
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    The common term is "paper profit", the technical term is "unrealized gain". – Barmar Feb 26 at 14:52
  • FWIW, ignoring fees is pretty reasonable these days, since we have online brokerages (e.g. Ameritrade, Schwab, etc.) with $0 commissions on stocks and ETFs. – reirab Feb 27 at 22:51
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You're trying to "time the market" which has proven to be a losing strategy in the long run. In your scenraio, if you could sell partial shares (i.e. 1.67 to extract the $20 profit), then wait for the drop to $5 to buy 4 more, you'd have 12.33 shares. The problem is that those shares are now worth $5 each for a total of $61.67, so you still have an overall loss of ~$30.

If you had instead sold the whole lot at $12 then re-bought at $5, you'd still have just $120 worth of stock, but more shares (24 shares instead of 10).

But there are a lot of "what ifs": What if the stock rose the next day instead of falling? What if the stock fell the first day instead of rising? You can set up all types of theoretical scenarios to capture profit, but there's no way to predict what's going to happen to know if you should buy, sell, or hold.

That's not how "stock compounding" works. Stock returns work like compound interest because that's how the growth of the underlying companies tends to behave. Companies look at growth in relative terms, like 20% per year, so that growth "compounds" and thus the value of their stock compounds. There is no strategy needed to force stock investments to grow exponentially on average.

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  • I see. makes sense. based on what you are saying it almost sounds like it's best just to leave your investment be, ride the stock value roller coaster, then dump at the highest price? – itsmevic Feb 25 at 19:40
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    @itsmevic It depends on your strategy. For long-term growth yes buy-and-hold is the best strategy, possibly with some tactical reallocation after large moves. There are "technical" traders that look for patterns in short-term movements, and some that "day trade" trying to catch these types of swings. There's not much evidence that either of then outperforms the overall market on average, though. – D Stanley Feb 25 at 19:43
  • @NotThatGuy My point was that you could monetize the $20 gain, leaving the account with the initial $100 investment. You'd sell 1.67 shares to do that. – D Stanley Feb 26 at 17:34
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    @jamesqf "buying low and selling high"/"unless you think the price is likely to go higher" - That is timing the market though. When the price goes up to $12, you don't know if it's high, or if it's about to go up even more. Maybe tomorrow it'll be $15 but you sold it to buy something else. – Matthew Crumley Feb 26 at 21:48
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    @jamesqf the claim is not "timing the market doesn't work" - the claim is "on average, buy and hold is at least as good as timing the market" - selling high sometimes misses out on more gains, holding and riding the market, the poster is arguing, over time will beat attempts to time the market – Stephen S Feb 27 at 21:42
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That same stock price the next day goes to $12.00 dollars per share. You've made $20 dollar profit

On paper you have a profit. But you have to sell the shares to get the actual profit.

If the stock drops the next day to $5 dollars, withdraw your profit of $20 dollars and then use buy back into that same stock at now $5 dollars a share.

If you didn't sell yesterday then your 10 shares are worth $5 each for a value of $50. Now If you did sell yesterday then you can take your $120 in cash and buy 24 shares.

Of course you have to be able to time the market perfectly for this to work.

Stocks don't have compound growth.

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    Stocks do have compound growth. If a stock goes up 5% today and 5% tomorrow, someone who holds the stock gains 10.25%, not 10%. – David Schwartz Feb 25 at 20:44
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    @Mhoran_psprep I think the last sentence should be reworded for clarity - stocks do have compound growth, meaning that if you hold $100 in stock that goes up 5% this year, and 10% next year, and 6% the year after, your total ending value would be $100 * 1.05 * 1.1 * 1.06 = $122.43, instead of $100 * (1 + 5% + 10% + 6%) = $121. The point is that when calculating proportionate annual return, the value increase you get today, will enlarge the amount of value increase you get tomorrow. – Grade 'Eh' Bacon Feb 25 at 20:46
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    Stocks do have compound growth, as long as you re-invest the dividends rather than spending them on other things. Growth-oriented mutual funds will do this for you automatically. – Mike Scott Feb 25 at 21:20
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    @mhoran_psprep Right but that's not what compounding means in the traditional sense. Compounding refers to the idea that gains are multiplicative, and that's why $100 growing at 10% / year is worth more than just earning $10 per year. The fact that the rate of growth is unknown in advance is a question of risk, not compounding. – Grade 'Eh' Bacon Feb 25 at 21:38
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    @MikeScott However, stocks have compound growth even if they never pay out a dividend at all. A dividend that is not paid is retained profit and is added to the value of your stock in an equivalent way to if they were paid and you reinvested (ignoring the effect of taxes etc.). – JBentley Feb 27 at 2:46
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Compounding of an investment in a stock is not something that happens directly.

If you put money in an interest bearing account (such as a savings account, money market account, etc.) then each compounding period you are going to earn interest which is then credited to your account. Then in the next period you are going to earn interest not only on your original deposit, but also on the interest earned in the first period.

When you purchase stock, the idea is that indirectly your investment will compound under the management whoever is running the company. For instance, if the company sells widgets, they will reinvest some of their profits to buy more machines to make widgets so that now they can sell a larger number of widgets and earn greater profit. This of course assumes that there is demand for additional widgets which nobody is satisfying, otherwise the extra widgets wont sell and the company may take a loss instead.

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