Compounding interest with stocks?
 

I have this Motley Fool book on strategic investing and whatnot... and all throughout the book they keep talkin about picking a portfolio that will outperform the S&P 500.

Now, they frequently mention, "$10,000 invested over 20 years becomes $80,623 at the 11% average of the S&P 500"

I have a fake portfolio I set up 2 years ago that has had consistent returns of over 25% (right now, it's 27.46%), yet the value... is exactly 27.46% of my initial "investment".

Where is the compounding effect I'm hearing about?

Something doesn't make sense here... let's say this 25% return remains consistent over 10 years. Based off the initial $1655, I will have $15,413.

There's only 6 stocks in this portfolio with 10 shares each, so that means each stock, on average, would have to be $256 per share. After 20 years when it should be worth $143,548, then each share should be $2392 per share.

Um... yeah, something isn't quite right with that...

So yes... where and how is this compounding effect taking place?

This assumes that none of the shares split for 20 years. Not likely.

What the book means is that each year the portfolio gains 11%. Your portfolio is probably saying that the total gain is 27.64%

Unless I misunderstand your question, which is possible...

The book doesn't account for splits.

What it does is start off by saying, "Invest in the s&p 500 and you'll get, on average, and 11% return each year. Over 20 years that's $80k."

Then it goes on to explain how one should aim their long term investments into stocks (by using common sense, of course) and try to beat the 11% gain each year by the S&P.

It doesn't mention anything about splits, but it does keep explaining how your growth over the long term is due to compounding. Nor does it account for "when the stocks grow, sell them and buy more of the others at lower costs." It just assumes you have a chunk of money and when you invest it, you'll forget about it for x amount of years. Of course, you also need to keep up to date on the quarterly/annual financial reports of each company to make sure they aren't sucking.

But yeah, they're definitely talking about compounding, not splits or whatever else.

I really don't get where this money is coming from.

Compounding works like this...

Let's assume you have $10,000.00 invested in something with 11% interest for 5 years...

Year 1 - 10,000.00 x 111% = $11,100.00
Year 2 - 11,100.00 x 111% = $12,321.00
Year 3 - 12,321.00 x 111% = $13,676.31
Year 4 - 13,676.31 x 111% = $15,180.70
Year 5 - 15,180.70 x 111% = $16,850.58

And so on and so forth.

There are a ton of little nuances as to how it is done, but this is assuming that it is compounded annually. In all likelyhood, it would compound far more often than that.

When dealing with compound interest, the main thing is length of time - it is ridiculous how much you will have after many years based on a relatively small initial investment. The reason I multiplied by 111% is because I wanted to account for an 11% gain in the investment throught the year.

Make a bit more sense?

No, I know how the compounding works.

My question is... where is the money from this compounding coming from if your investments are statically linked to stocks?

Like the example I used in my first post... the portfolio actually had a 45% return the first year, and roughly 25% the second year off the initial $1655 investment.

So you have:

$1655 * 1.45 = $2399 (first year)
$2399 * 1.25 = $2999 (second year)

At least, that's what's being explained to me, yet... there's only $2109 in there now. There's been nothing compounded. Why not?

The portfolio currently has the 27% gain, but if stocks go down, others go up and it REMAINS at 27%, then... it doesn't matter if it's 10 years from now, it will still only be 27% of 1655.

See what I'm saying? From what I'm seeing, after year 1, the portfolio had a return of 45%. Then it DROPPED back down to 25%.

In the example I used in one of my above posts... let's say there was always this 25% gain on the portfolio. After 10 years I'd have $15,413. If I only have 6 different companies @ 10 shares each... then each share on average would have to be around $256.

Of course.. that's an outrageous price. So I'm missing something regarding the compounding.

You are misunderstanding what that 11% number is. That 11% number is the annual return.

Your 27% number is the 'total return since you bought your investment', not the annual return.

The annual return on your investment was:
+45.0% in year one
-12.4% in year two

You lost money in year two. You did not gain 27% in year 2.

If your investment goes up by 25% per year for 10 years, how much will it be worth in 10 years?

The actual price of shares is pretty meaningless.

Companies can sell fractional shares, merge shares, or split shares at will.

Traditionally a company will split its shares when the value of a single share gets too big.

So you start with 10 shares @ 40$ per share share.
Every year it increases in value by 25%.

Year 0: 10 shares @ 40$
Year 1: 10 shares @ 50$
Year 2: 10 shares @ 62.5$
Year 3: 10 shares @ 72.125$
Year 4: 10 shares @ 97.66$
Year 5: 10 shares @ 122.07$
at this point, the company says "hmm, 122$ per share is silly. Lets split our stock!
Year 5: 20 shares @ 61.03$
Year 6: 20 shares @ 76.29$
Year 7: 20 shares @ 95.37$
Year 8: 20 shares @ 119.21$
damnit, shares cost too much again. This time they do a 3 way split on shares.
Year 8: 60 shares @ 39.74$
Year 9: 60 shares @ 49.67$
Year 10: 60 shares @ 62.09$

How much is your investment worth after 10 years?
400$ initial investment, compounded at 25% annually:
400$ * 1.25^10 = 3725.29$

When shares split 3 ways, you get 3 times as many shares, that are each worth 1/3 as much.

Lastly, 25% return per year is not anything you are going to get.

First of all, you want to look at after inflation returns. You can get a 25% return if there is 24% inflation. =-) But that doesn't do much good, because your money gets worthless as fast as you earn more of it!

Second, unless you have a super sekret trick, you should not expect to get much more than a few % over inflation. Like 2% over inflation.

So, 20,000$, at 2% after inflation, will grow to 29,719$ inflation-adjusted dollars in 20 years.

Assuming a nice slow average inflation of 4% over those 20 years, that will end up being 65,118$ in paper money -- but paper money will be worth 2.2 times less in 20 years, so it will have the buying power of 29,719$.

Lets suppose you get a really good investment that returns 4% over inflation for 20 years. Then your 20,000$ turns into 43822$ (inflation-adjusted) or 96k$ in paper money.

Going from 2% to 4% upped your return of your investment from under 10k$ to over 23k$.