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I've been trying to understand the multiple ways stocks and bonds compound (under the definition of compounding as generating earnings from the reinvestment of previous earnings, my understanding of the term). Is the following correct?

Stocks:

  • Reinvestment of dividends
  • Reinvestment of capital gains

Bonds:

  • Reinvestment of coupons
  • Reinvestment of dividends (in just a few types of bonds)
  • I'm not sure what you mean - do you mean an individual stock or bond, or investments in general? What is your goal? – D Stanley Apr 1 '17 at 21:01
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    Yes, it is correct. – Simon B Apr 1 '17 at 23:01
  • @DStanley Both investing in stocks and bonds from within mutual and exchange-traded funds, and investing in them individually. I'm just asking for general curiosity, not a specific personal situation. – Natalie Apr 2 '17 at 1:29
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Only interest on savings truly "compounds", but you can get a similar effect by reinvesting gains on investments, whether it be stocks or bonds. The overall value of the equity (stock) market tends to increase exponentially (which has the same mathematical effect of compounding interest) because companies take the earnings that they make and reinvest part of them back in the company. Thus the companies themselves reinvest their earnings, which is reflected in the stock prices. Dividends do not factor into compounding because when a company issues dividends, the cash is removed from the company, and the value of the company (and the stock) drop proportionally. e.g. If a company issues a $1 per share dividend, the value of the stock drops $1 after the dividend is paid. If you reinvest that dividend in the same company, you still have the same total amount invested in the company.

Bonds do not "compound" in that sense. Most pay out interest periodically, which you can reinvest into other investments, but the vast majority of individual bonds themselves do not compound their interest. However, the value of a bond (meaning what buyers are willing to pay for a bond) takes compounding into effect in a way. A zero-coupon bond (meaning a bond that pays no interest), will be sold at a discount equivalent to the effect of compounding the returns on an investment of similar risk. So a $1,000 5-year zero-coupon bond that sells for $783.53 has an "effective" interest rate of 5%, since if you "saved" $783.53 at 5% annual interest, in 5 years you'd have $1,000. The market has determined that 5% is a reasonable annualized return for an investment of that risk.

  • By that logic, would it be fair to say that reinvesting stock dividends does not actually increase wealth? – Natalie Apr 2 '17 at 6:24
  • @WalletSage It's fairer to say that cashing out dividends reduces returns in the long run. It would be like taking $10 out of your savings account each month. You still get compounded interest but your overall growth is slower. My point was more that even stocks that don't pay dividends compound over time if they reinvest their earnings in the growth of the company. – D Stanley Apr 3 '17 at 13:49
  • I understand what you mean regarding the overall value increase of stocks due to their reinvestment into themselves. But regarding stock dividends, because the value of the stock drops as a result of removing cash from the company after compounding, it seems like the overall effect may not be that reinvesting them (purchasing additional shares) may not actually make you any more money, or at least the net wealth increase may be minor. Is that right? – Natalie Apr 3 '17 at 21:41
  • @WalletSage In the short term, yes. If you withdraw $10 from your savings account you have not gained anything. If you then put it back in savings (or in a different savings account) then the $10 will compound like it would have originally. So there is a long-term effect with reinvesting dividends versus cashing out, but the root cause is the same as if the company did not pay dividends. – D Stanley Apr 3 '17 at 21:45
  • With the savings account example, it seems a more apt analogy (of taking dividends out vs reinvesting them to buy additional shares) would be withdrawing the interest gained on the principal vs allowing that interest to remain in the account, thus adding to the principal future interest is calculated from (assuming stock dividends are additional as with savings account interest). I probably am not understanding dividends correctly. – Natalie Apr 4 '17 at 22:47

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