Compound interest can be a saver’s best friend and it’s also a valuable tool for investors. In simple terms, it means the interest you earn on your interest. But how does compound interest work with stocks, mutual funds or other securities? Understanding what it means to earn compound interest from investments is key to developing a wealth-building strategy.
A financial advisor can walk you through different compound interest options for your savings needs and goals.
What Is Compound Interest?
Compound interest is the interest on your interest. More specifically, it’s interest that’s earned on the principal and the interest that accumulates over time.
Here’s a simple example of how compound interest works. Say you deposit $10,000 into a savings account that has a 2% APY. At the end of one year, you’d have $10,202, assuming that interest compounds daily. After two years, that amount would grow to $10,408 and after 10 years, you’d have $12,213.
You’re not making any additional deposits to the account. But because you’re earning interest on your principal and interest through compounding, your money continues to grow.
That’s the chief benefit of compound interest and why it’s preferable to simple interest. With simple interest, you only earn interest on the principal deposit. Over time, compounding interest can prove to be much more powerful for building wealth.
How Does Compound Interest Work With Stocks?
Investing in stocks can help you to benefit from compound interest at a potentially higher rate and over a longer period of time. While they carry greater risk, stocks can deliver bigger returns. Instead of earning 2% from a high-yield savings account, you might earn a 10% or even 15% annual rate of return from stocks.
In terms of how compound interest works with stocks, it follows the same rules as compound interest for savings accounts. Your rate of return can depend on:
- How much you invest
- Interest earned
- Investing period
The more time you have in the market, the longer you have to benefit from compound interest. Here are some examples of how compound interest on stocks works, using different investment time frames.
Example 1: 12-Month Investment
Assume that you have $10,000 to invest. You want to buy 100 shares of XYZ stock, valued at $100 each. You plan to hold those shares for one year and anticipate earning a 7% annual rate of return.
At the end of one year, you’d have $10,700. But what if you purchased an additional $500 worth of shares each month? Now you’d end up with $16,700 instead.
Example 2: 5-Year Investment
Now, let’s assume you purchase $10,000 worth of the same stock and earn a 7% annual rate of return for the next five years. At the end of that time period, you’d have $14,025.52, of which $4,025.52 represents the compound interest earned.
That total reaches $48,529.95 if you purchase an additional $500 worth of shares each month over that five-year period. Of that amount, $8,529.95 represents the compound interest earned.
Example 3: 30-Year Investment
How much money could you end up with if you invest in the same stock for 30 years? If you were to purchase $10,000 worth of shares and make no other deposits, you’d have $76,122.55 after three decades.
Again, that’s at a 7% annual rate of return. If you were to invest another $500 a month into the same shares, your money would grow to $642,887.27 over a 30-year period.
These examples all assume that interest compounds annually. It’s important to note that interest can compound at different frequencies, including daily, monthly and quarterly, depending on where you’re keeping your money. You can use an investment calculator to run different scenarios for returns.
The point, however, is that compounding can be a good thing from an investing perspective. Even if you make a one-time stock purchase and never buy another share, you could still end up with more money than you started with thanks to compounding. That assumes, of course, that the stock continues to generate a positive annual return for each year that you hold it.
How to Make Compound Interest Work for You
Using compound interest to your advantage as an investor isn’t that difficult. The first step is to simply start investing.
Waiting to start investing could cost you in a big way if you’re missing out on valuable compound interest. Say, for example, that you want to start investing for retirement. You open a Roth IRA and invest $6,000 a year into exchange-traded funds that hold a mix of different stocks.
If you start saving at age 35 and earn a 7% annual rate of return, you’d have $498,172 by age 65. Now, what if you start investing at age 25 instead? In that case, you’d end up with $971,544 instead, nearly doubling your money. That example shows just how important the time factor can be when taking advantage of compounding interest.
Aside from getting an early start, you can also make compound interest work for you by being consistent with your investments and choosing the right stocks. The obvious goal is to select stocks that are likely to increase in value over time. That’s at the core of a buy-and-hold strategy.
Researching different stocks can help you to choose ones that are likely to be a good fit for your portfolio, based on your investment style and risk tolerance. Value stocks, for example, may be appropriate if you’re looking for stocks that are undervalued by the market and are likely to appreciate over time. You may also benefit from earning current income from these stocks in the form of dividends.
Opening an online brokerage account can be a simple way to get started with stock investing. Depending on the brokerage, you may be able to trade individual stocks and ETFs with zero commission fees. You may also have the option to invest in mutual funds, bonds, IPOs, options, forex or cryptocurrency.
If you’re not sure where to start with stocks, then talking to a financial advisor can help. An advisor can break down the basics of how stocks work and how to create a diversified portfolio. They can also offer advice on how to leverage tax-advantaged accounts, such as a 401(k) or IRA, as part of your investment plan.
Compound interest is one of the simplest investing concepts, yet its importance is often overlooked. If you’re not investing in stocks yet, then you could be passing up a chance to benefit from this concept. Even if you can only afford to invest smaller amounts to start, you can still see gains over time thanks to compounding interest.
- Consider talking to your financial advisor about different stock strategies and how to use them to further your financial goals. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you’re interested in leveraging compound interest, it’s helpful to understand the principle of dollar-cost averaging. With dollar-cost averaging, you continuously invest money, regardless of what’s happening in the market. The idea is that by doing so, you can smooth out variations in stock returns caused by rises or dips in volatility. That’s different from value averaging, which dictates investing more or less money over time, based on the current value of your investments. Again, those are things your advisor can help you to better understand when implementing your investing strategy.
Photo credit: ©iStock.com/Kateryna Onyshchuk, ©iStock.com/Antonio_Diaz, ©iStock.com/scyther5