4

I've always read that the great benefit of 401k's and IRA's are the compounding of interest.

My entire 401k invests in a S&P index fund and I make semi-monthly contributions and there is one annual profit sharing deposit from my employer.

So, how exactly is my 401k compounding if it doesn't earn interest?

8

You buy a share of something for $100. It goes up by 10% over a year, and you now have $110 in value. It goes up by 10% next year and you now have $121. That original $10 increase was compounded even though you're not earning interest because the gains are measured as a percentage. If, instead, you'd only invested the second year you'd have less value. Assuming the markets average a positive gain (above inflation) you see greater gains the earlier you're invested.

  • 1
    David - I DV'ed you, but on further reflection, you were correct, in my opinion. Votes are locked until edited, so I added/removed a period to allow myself to negate DV and upvote. Just coming clean here. – JTP - Apologise to Monica Oct 23 '14 at 22:50
6

During the course of the year, the S&P individual stocks will have some dividends. Not every last stock but a good number of them. Enough that the average dividend for the S&P has been about 2% recently.

So if the S&P index goes up, say 10%, an S&P fund should go up closer to 12%.

For a fund holder, you'd normally see a declared dividend and cap gain distribution toward the end of each year. When you hold shares in a 401(k), dividends are reinvested into the fund, usually with no involvement from the members.

2

You might be confusing two different things.

An advantage of investing over a long term is the compounding of returns. Those returns can be interest, dividends, or capital gains. The mix between them depends on what you invest it and how you invest in it. This advantage applies whether your investment is in a taxable brokerage account or in a tax-advantaged 401K or IRA. So, start investing early so that you have longer for this compounding of returns to happen.

The second thing is the tax deferral you get from 401(k) or IRAs. If you invest in a ordinary taxable account, then you have to pay taxes on your interest and dividends for the year in which they occur. You also have to pay taxes on any capital gains which you realize during the year. These yearly tax payments are then money that you don't get the benefit of compounding on. With 401(k) and IRAs, you don't have to pay taxes during these intermediate years.

1

Sure, stocks don't pay interest. I just looked up the word "compound" in a couple of dictionaries and the relevant definition in all of them just mentioned interest and not growth in the value of stock. So it may be technically inaccurate to talk about "compound growth" of a stock. I'll yield to someone more knowledgeable about the technical language of finance to answer that part.

But regardless of whether the word strictly applies, the concept certainly does. Suppose you put $1000 into a mutual fund and the fund grows by 10%. You now have $1100. The next year the fund grows by 15%. So you gain 15% of what? Of your original $1000? No, of your present balance, $1100. The effect is the same as compound interest.

There is the fundamental difference that interest is normally a fixed rate: you get such-and-such percent a year as spelled out in a contract. But change in the value of a stock depends on many factors, none of them guaranteed.

  • +1 - I agree with your introduction, and think the usage has morphed to the meaning that David Rice offered. If my $1000 stock grows to $2000 in 7 years, David would agree the CAGR is 10% (rounded to nearest digit). We don't care what it was in between for this calculation. I like my own answer below, but David's approach is in common usage, and mathematically correct. – JTP - Apologise to Monica Oct 23 '14 at 22:48

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