# How does compound interest work with stocks? [duplicate]

I just learned about compound interest, and I want to know if I understood it right: You buy a stock, and then you just keep it. And over time, you will just earn interest on your interest. Is that correct? You have to do nothing else than to just buy a stock and wait. Because in the videos I watched, compounding was explained as re-investing your interest, which implies that you have to take an action to re-invest it. But really, all you have to do is just not take the gained interest out, right? Because I mean, if you buy a stock at 100\$ and it grows to 110\$ and you sell the stock at 110\$ just to buy it again at 110\$ dollars (as to re-invest your money) you'd be at the same place as if you had just never sold the stock at 110\$. Am I correct in my assumptions? Please explain it to me, because I'm confused.

In order to receive compound interest, all I have to do is buy a stock once and then wait, and the compound interest will accumulate automatically, without me having to do anything for it. Is this correct? Thank you for your answer!

• I disagree that this is a duplicate. Although the linked question does address some of the core parts of the question. I think this question has value as a separate question especially for someone like OP that may not be as familiar with the mechanics of dividends and compounding value of stocks. – JohnFx Sep 11 '18 at 14:21
• I couldnâ€™t agree more that this question has deep value on its own. Specific questions get specific answers and make a lot more sense to newbies because they have more context. I wish the moderators at the various stack exchanges placed more value on this key insight about learning, instead of their gold badge that they get from marking duplicates. – mbigras Jul 7 '19 at 18:19
• Compound interest comes from earning interest on interest. Someone offers you 10% return per \$100 paid annually, then after one year you have \$110. Now you make 10% on \$110, so after year 2 you are at \$121, and so on. The interest earns interest because it's reinvested. Stocks are a reflection of the value of a company. Companies inherently make a return on money (or they fail to exist). When they make a return some of it is reinvested back in the company, and the reinvestment makes a return too (like the \$10 above) and so on. Reinvestment makes the value, therefore the stock price, compound. – James Bender Feb 4 at 14:49

Well, to clear up terminology, stocks do not pay interest. Many pay dividends, which you can sometimes choose to either take as cash or to reinvest (meaning either take the dividend in stock or buy more stock with the dividend), which then works much like compounding interest. However, the price of the stock drops by the same amount as the dividend, so it is a wash from an investment standpoint.

The gains in stock investing come from the growth of the underlying companies, and the reflection of that growth in their stock prices. So if a company grows at 10% per year, their stock price (all else being equal) should grow at that rate as well.

Also, in bank accounts and similar investments, interest is guaranteed, but stock returns aren't. Stocks can (and often do) lose value. A single stock will often be much more volatile (have greater ups and downs) that the market as a whole will. So "buy and hold" is a good long-term strategy, but is less risky when you have many stocks (or mutual funds) in your portfolio.

If you look at the market over long periods of time, then the math looks similar to the effect of guaranteed compound interest, but with single stocks and with shorter investment time frames, there is much more risk that needs to be taken into account.

So to answer the question, yes, investing in stocks can lead to compound growth like interest on average, but only over long periods of time, and there will be years of growth above and below that average.

• Considering the basic nature of the question, I think this answer would be improved by addressing their understanding of compound interest and whether or not that matches how things work when you are getting interest (with examples of places where you would). – KRyan Sep 10 '18 at 15:46
• You also have to pay taxes on some dividends, which reduces the compounding effect. – IllusiveBrian Sep 10 '18 at 17:43
• @IllusiveBrian Interest is taxable in the US too, so that's not a big difference. – D Stanley Sep 10 '18 at 18:41
• (@IllusiveBrian) in fact in the US, subject to some conditions that are usually met, dividends are 'qualified' and taxed at lower rates or in the lowest bracket not at all (0% rate), while interest is taxed at your full rate (unless you have deductions available to offset it, like any other income) – dave_thompson_085 Sep 12 '18 at 16:43
• You said "the price of the stock drops by the same amount as the dividend," why is that? – Robert Houghton Jul 2 at 1:31

You are apparently mixing up stocks and other forms of investments.

As others have said, stocks usually pay dividends, not interest. There is usually no fixed rate, a stock will not pay a fixed "10% dividend".

A savings account for instance will pay interest. Depending on which country you are in, there is usually a wide variety of other types of investments which work the same (with variations in terms of payout, taxation, obligation to keep the investment for a given duration, etc.). On those types of investments, usually (but not always), interest will be paid into the same account, and will thus get interest as well in the next period, and then it repeats again and again.

There are ways to reinvest dividends of stocks into more stocks, most often in investment accounts that are composed of a portfolio of stocks. These can then act like a savings account, but, as other have said, if it's based on stocks, it's a lot riskier than a savings account, as stock values can drop during crises. Not only is there no fixed return, but even your principal (what you invested) could reduce (a lot).

I just learned about compound interest, and I want to know if I understood it right: You buy a stock, and then you just keep it. And over time, you will just earn interest on your interest. Is that correct? You have to do nothing else than to just buy a stock and wait. [...] really, all you have to do is just not take the gained interest out, right?

This is a more-or-less correct description of compound interestâ€”except for the word â€śstock.â€ť Stocks donâ€™t usually1 offer interest, so buying a stock wouldnâ€™t usually cause you to earn interest, compound or otherwise.

But if you bought into something that does offer interestâ€”which could be as simple as putting money into a savings account, but many other options existâ€”this would be an accurate description. You would earn interest, and in most cases that interest would simply be put into the interest-earning accountâ€”where it will count towards future interest you might earn from that account.

E.g. 10% interest on \$100 would net you \$10â€”which means your account is now at \$110 and your next 10% interest is \$11 instead of \$10. Note this doesnâ€™t happen if the interest is taken out of the account (and in some cases, interest wouldnâ€™t be able to join the rest of the account at all, so you would not experience compound interest at all).

Because in the videos I watched, compounding was explained as re-investing your interest, which implies that you have to take an action to re-invest it.

Thatâ€™s usually correct: stocks donâ€™t usually pay â€śinterestâ€ť at all, but rather â€śdividends,â€ť which is just money you get and you can do what you like with. If you go ahead and reinvest that money, then the result is rather like compound interestâ€”the money you have already made is increasing the money you can make in the future. This isnâ€™t automatic.

But dividends also arenâ€™t primary way to earn money from a stock. The primary way in is by selling them later, after their value has gone up. The change in the stockâ€™s value is automatic. In some ways (for instance, from the perspective of most tax authorities), you have automatically gained wealth if the value of stocks you own has gone up. This doesnâ€™t really â€ścompoundâ€ť though, except in the abstract sense that the stockâ€™s value has gone up because the company is strongerâ€”and being a stronger company, might be in a better position to increase their value even more.

And ultimately, you would still have to choose when to sell the stock to realize the profit, so even though the value changes â€śautomatically,â€ť you wonâ€™t actually be able to use that wealth until you sell, and thatâ€™s not automatic at all (choosing when to sell and when to buy is immensely difficult). Once youâ€™ve sold, assuming you made a profit, you now have more moneyâ€”and again could funnel that back into new investments to hopefully â€ścompoundâ€ť your gains, in a manner of speaking.

Importantly, though, interest is usually guaranteed; if you buy into an interest-earning account, usually whoever took your money owes you that money as well as the agreed-upon interest, on the agreed-upon schedule. If they donâ€™t provide it, you can sue them to get it.2 If they canâ€™t provide it, usually these things are insured (legally must be insured) and so the insurance company will pay it to you insteadâ€”and again, if they didnâ€™t, you could sue them to get it.2

Investing doesnâ€™t work like that. When you invest, you are entitled only to get your slice of whatever money comes out of the investment, and nothing else. If no money comes out of the investment (company does poorly or whatever), you get nothing. If the company goes bankrupt, you not only get nothing, but also canâ€™t sell your investment to anyone else because it will have no value. Investing always involves some risk. As other answers have suggested, diversifying is the tried-and-true way to mitigate those risks.

In order to receive compound interest, all I have to do is buy a stock once and then wait, and the compound interest will accumulate automatically, without me having to do anything for it. Is this correct? Thank you for your answer!

No, this is not correctâ€”for stocks. Itâ€™s correct for things that actually earn interest, more or less, but not for stocks. For stocks, dividends have to be invested if you want to â€ścompoundâ€ť them, and moreover, stocks involve risk and so nothing with them is â€śautomatic.â€ť You might accumulate moneyâ€”or you might lose it.

Say you invest 100\$ into a stock, and it goes up 10%, so you made 10\$, so now you have 110\$. If you now just do nothing and just keep your stock that's worth 110\$ and the stock goes up 10% again, you'll earn 11\$. So now you have 121\$ and you earned compound interest, and you didn't have to do anything for it.

You have to be careful here: up 10% from what? Percentages are always of something. Since interest payments are always made on a regular schedule in regular amounts, this is clear and we leave it out: each payment is made based on the amount in the account prior to the payment. But stock values fluctuate constantly: you have to arbitrarily choose some point as your reference, and then say its value is â€śup 10%â€ť from that arbitrarily-chosen reference point.

If you say that the stock was worth \$100 at point A, and at point B was up 10% from its point-A value, and then at point C was up 10% from its point-B value, then yes, your description is accurate. But points A, B, and C are all arbitrarily chosen: you could have chosen different ones and had different percentages. For example, suppose I said yesterday that it was up 10% from last month, and then said today that it was up 10% from last year: itâ€™s entirely possible that the price hasnâ€™t changed between the two days, if its price last month happened to be the same as the price last year. It hasnâ€™t gone up 10% â€śtwice.â€ť And, for that matter, it could have lost money between yesterday and todayâ€”maybe yesterday it was up 15% over last year, but it took a big plunge and gave up a big chunk of value, and is now only up 10% from last year. You need to keep careful track of the reference points.

All that really matters, in terms of how much wealth you have, is the stockâ€™s value today, not what its value used to be. (How it has changed over time can be important in deciding whether to buy or sell stock, of course.) This is very different from compound interest, where your 10% payment is \$11 because of the previous \$10 payment. With a stock, the value can (and almost-certainly will) go up one day and down another, and its past value is only indirectly relevant.

Always remember: past performance does not guarantee future results.

1. The word â€śusuallyâ€ť would need to appear in quite a lot of places in this answer; to make things easier to read and keep things more basic, I will be leaving most of them out.

2. Really, you â€ścan sueâ€ť for pretty much anything. What I mean here is that you can sue, and have a reasonable expectation of success. You are legally owed that money and the court should back you up on that if necessary. Finding a lawyer to represent you wouldnâ€™t be difficult and a court would take the matter seriously. On the other hand, if you couldnâ€™t demonstrate any legal right to the moneyâ€”for example, if this were an investment and not a guaranteed interest-earning accountâ€”, youâ€™d probably not be able to find any lawyer to represent you and probably wouldnâ€™t find any court willing to allow you to represent yourself. If you actually managed to get that far, youâ€™d be laughed out of courtâ€”if not fined for wasting the courtâ€™s time.

• – KRyan Sep 10 '18 at 19:58
• First of all, thank you very much for taking the time to write this extensive answer! I feel that I have a better understanding now, but there are still two things unclear to me: (accidentally sent this comment early, questions come in a following comment) – heresmyname Sep 11 '18 at 18:14
• You said: "For stocks, dividends have to be invested if you want to â€ścompoundâ€ť them, and moreover, stocks involve risk and so nothing with them is â€śautomatic.â€ť You might accumulate moneyâ€”or you might lose it." Here's what I don't understand about that: Say you invest 100\$ into a stock, and it goes up 10%, so you made 10\$, so now you have 110\$. If you now just do nothing and just keep your stock that's worth 110\$ and the stock goes up 10% again, you'll earn 11\$. So now you have 121\$ and you earned compound interest, and you didn't have to do anything for it. – heresmyname Sep 11 '18 at 18:19
• You just had to hold on to the stock. Isn't that correct? – heresmyname Sep 11 '18 at 18:19
• @heresmyname I have responded to your comments in my answer. Your numbers can be correct, but there is still a large, important difference between compound interest and stock value that I fear you might be missing, so I tried to explain the distinction some more. – KRyan Sep 12 '18 at 16:53

Most common stocks pay dividends. Some preferred stocks pay a combination of interest and dividends. If it's a non sheltered account, both are usually taxable.

If you reinvest your dividends and share price appreciates, those dividends will provide compounding. Interest compounds IF you are receiving interest on your cash balance but at today's low rates, it's peanuts. Some brokers do not pay interest on cash balances.

As for buying a stock for \$100 then selling it for \$110 and buying it back for \$110, you may or may not be 'at the same place' because if non sheltered, you'd have to pay taxes on the \$10 capital gain.