- December 12, 2023
- Posted by: legaleseblogger
- Category: Related News
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Understanding Compound Interest in Fund Investments
I’m seeking clarification regarding the concept of compound interest as it relates to my investments in funds. I am familiar with the concept when it comes to cash investments, but it’s a bit hazy for me when it comes to funds. I know that when you invest in cash, you earn interest, and that interest also earns interest over time. However, when I look at my investments in funds, it’s not immediately clear to me how compound interest applies.
As far as I can tell, when I invest in a fund, I am essentially purchasing units of that fund, and the value of those units may grow over time. But does compound interest come into play here as well? Is the growth in value of the fund units somehow related to compound interest? I’ve also come across discussions about reinvesting dividend values, and I’m not sure if that only applies to accumulation funds. I feel like there might be something significant that I am overlooking in understanding how compound interest works in the context of fund investments.
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I think itÔÇÖs the word interest that is confusing you. Think of it as the compound growth.
If you start with a 100 and it grows by 10% the first year youÔÇÖd be on 110. If it grows by 10% again youÔÇÖre getting 10% of 110 not your starting figure of 100. ThatÔÇÖs the compounding.
the word “interest” confuses things here. really it’s the profits companies make or the dividends they pay out which can compound. dividends directly compound when you re-invest them. the companies re-investing profits into the company can produce more profits and hence the share price to goes up. and for some elements in the stock market there’s no compounding at all as they might be an early stage company developing products which don’t yet make profits so the share price might go up without any type of compounding. the phrase people should use is compounding returns. and returns can have a few different origins. dividends, rising profits, rising valuation.
the dividend re-investment aspect of the compounding returns don’t just apply to accumulation units. if you owned the inc units and bought more units with the dividend payments it works the same. it’s just instead of having x units with a higher unit price you would have x+y units with a slightly lower unit price. total amount would be similar with differences of transaction costs and the dividend being out of the market for a couple of months maybe. you might choose the inc units for simpler tax returns if it’s outside of a tax wrapper. or if you have various investments you might want to choose where the dividends go to re-balance a little.
The companies make and sell stuff, make a profit, and they reinvest some of that money back in the company (like buying a bigger factory or employing more people), making the company bigger and able to make more stuff and make more profit next time. Or sometimes they pay the profits back to you (dividends) which you can reinvest to buy more of other companies. Compounding is that this happens every year on both the initial amount you invested and the yearly growth which grows itself and so on.
It has been explained by others already, but to try and make it as simple as possible I’ll throw my explanation in too.
Imagine if you started with £1,000 and withdrew your profit every year, and put it aside as cash under the mattress to keep it safe. You keep your account only ever at £1,000.
10 years later, if the funds you choose have done well your £1,000 has grown, but the money under your mattress never did. You have £1,000 plus your pile of cash, not too bad at all.
However….had you kept it invested, each years profit could have grown too. Not only would your first years profits have grown, the profits on these profits would have grown in subsequent years too, on and on and on.
As you can picture once your profits grow too, as does the profit on your profit, and the profit on your profits profit, and the profit on your profits prof….it can lead to exponential growth, significantly more than had you kept the surplus under the mattress.
In your example, the number of units you hold may not change, but the value of each units does! If this were the ‘profit under the mattress’ example, to keep at ┬ú1,000 you would actually need to sell some units every year (if the fund has grown).
Calling it compound growth instead of interest might help you picture it more easily.
ItÔÇÖs a funny one, because compound interest doesnÔÇÖt happen with investments but the term still gets used. The value of your holdings go up, generally over time as the markets increase. If you use funds, you may have elected to receive dividends which are reinvested back into the fund, buying more shares in it.
Hey, there is already a few good answers so I won’t add anything but I suggest you try free online calculator like this one to get better visual representation of that:
[https://compoundwave.com/calculator/etf](https://compoundwave.com/calculator/etf)
on this website you can play and simulate your investment over time (looking on the historic data). Beside that on the bottom you get detailed breakdown what happen to the investment each month.
I suggest to you pay special attention to S&P 500 and S&P 500 with dividends reinvested to se what would happen in that case.
Hi /u/saswir, based on your post the following pages from our wiki may be relevant:
– https://ukpersonal.finance/investing-101/
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