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I continually see examples encouraging young people to start investing for retirement with graphic examples using compounding interest to show that starting early pays off big. I've always bought into this idea.

However, today I started thinking about it. Very few of us invest our retirement nest egg in an interest bearing account and expect interest to grow our money over our working lives. Anyone sensible enough to realize that interest rates are close to negligible recently would be crazy to rely on that strategy.

So my Question is this, in reality is investment in equities like the stock market even remotely resemble the type of growth one would expect if investing the same money in an account with compounding interest? Are all these prognosticators vastly underestimating how much savers need to be socking away by overstating what is realistic in terms of growth in investment markets?

  • Clarification: I'm not questioning the math of compounding interest, just whether investments like stocks realistically experience true compounding growth. – JohnFx Feb 2 '14 at 0:05
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    Why not look at a chart of Berkshire Hathaway and decide how real their compound growth has been? – JoeTaxpayer Feb 2 '14 at 0:12
  • Retirement funds are normally mostly in securities not cash - the major part of returns comes from reinvestment of dividends/coupons – Neuromancer Feb 2 '14 at 14:39
  • Interest bearing savings account are low returns these days and don't show the difference in results. However "Saving Early" and "Compounding" need not be restricted to savings account. Any instrument [stock/real estate/retirement account] if are giving "x" return, the compounding does make a different. – Dheer Feb 2 '14 at 16:46
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The S&P 500 index from 1974 to present certainly looks exponential to me (1974 is the earliest data Google has). If you read Jeremy Siegel's book there are 200 year stock graphs and the exponential nature of returns on stocks is even more evident. This graph only shows the index value and does not include the dividends that the index has been paying all these years. There is no doubt stocks have grown exponentially (aka have grown with compound interest) for the past several decades and compounded returns is definitely not a "myth".

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The CAGR on the S&P 500 index from 1974 to present has been 7.54%: (1,783 / 97.27) ^ (1 / 40) - 1

Here is another way to think about compounded investment growth: when you use cash flow from investments (dividends, capital gains) to purchase more investments with a positive growth rate, the investment portfolio will grow exponentially. If you own a $100 stock that pays 10% dividends per year and spend the dividends every year without reinvesting them, then the investment portfolio will still be worth $100 after 40 years. If the dividends are reinvested, the investment portfolio will be worth $4,525 after 40 years from the many years of exponential growth: 100*(1 + 10%)^40

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    +1 nice answer, but your first line ignores that the S&P index does not include dividends and that 7.54 understates the true return. – JoeTaxpayer Feb 3 '14 at 3:20
  • This graph and answer do not account for inflation. Also, previous returns are no guarantee or even indication of what future returns will be. – Comptonburger Jun 24 '16 at 20:36
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Compound growth isn't a myth, it just takes patience to experience. A 10% annual return will double the investment not in 10 years, but just over 7.

Even though a mortgage claims to use simple interest, if your loan is 5% and there's 14 years to go, $100 extra principal will knock off $200 from the final payment. The same laws of compounding and Rule of 72 are at play.

  • Actually, mortgages do use simple interest for all practical purposes as long as the payments are made in timely fashion. Each month (or every two weeks, depending on the terms), the mortgagee pays a fixed amount that covers all the (simple) interest on the principal amount still owed, plus a little bit more that reduces the principal amount owed during the next month. If the mortgagee pays a little extra, that reduces the principal owed during the next month. – Dilip Sarwate Feb 2 '14 at 0:13
  • Each month, the calculation for the next payment due is simple interest, I agree. When one makes an extra payment to principal, the math to figure out what the savings is off the final payment(s) is a compounded number, as counterintuitive as that might be. – JoeTaxpayer Feb 2 '14 at 0:29
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So my Question is this, in reality is investment in equities like the stock market even remotely resemble the type of growth one would expect if investing the same money in an account with compounding interest?

Generally no as there is a great deal of volatility when it comes to investing in stocks that isn't well represented by simply taking the compounded annual growth rate and assuming things always went up and never went down. This is adding in the swings that the market will take that at times may be a bit of a rude surprise to some people.

Are all these prognosticators vastly underestimating how much savers need to be socking away by overstating what is realistic in terms of growth in investment markets?

Possibly but not probably. Until we know definitively what the returns are from various asset classes, I'm not sure I'd want to claim that people need to save a ton more. I'll agree that the model misses how wide the swings are, not necessarily that the averages are too low or overstated.

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This post may be old anyhow here's my 2 cents. Real world...no. Compounding is overstated. I have 3 mutual funds, basically index funds, you can go look them up. vwinx, spmix, spfix in 11 years i've made a little over 12,000 on 50,000 invested. That averages 5%. That's $1,200 a year about. Not exactly getting rich on the compounding "myth?". You do the math. I would guess because overly optimistic compounding gains are based on a straight line gains. Real world...that aint gonna happen.

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