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?
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.
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.
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.
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.