Nope, you just sit back, relax and watch the price goes up. No need to sell and buy back again. When you are done, goals accomplished, you sell it at a very high price, inclusive of all compounding interests/profits earned over the years.

So say compounding rate is 5%. Starting amount is 100 dollars. One year after investment, it is worth 105. The year after it's 100*(1.05)^2 = 110.25. After N years, assume no top-up, you get 100*(1.05)^N. You don't sell, it keeps compounding; you sell, that means you realize your profits. And that's the final amount.

In reality it's far more complicated, you have dividends, unit splits etc. And not to forget the ups and downs which tend to invite speculations and lure people away from "investing" into "trading".

This post has been edited by TOS: May 15 2021, 10:52 PM

Compounding interest should be more appropriately called "compounding return".

Returns come in two form: capital gain and current income. Capital gain is the price appreciation of the asset you own, current income is the dividend/rent etc, you collect in a certain period of time "explicitly".

If shares are rather abstract, think of buying property, a house for example. You buy today at 500k. 10 years later when you sell it, it won't be 500k. Maybe a few millions. The difference between the selling price of a few millions and your initial purchase price (and minus tax and other transaction cost) is your return over the 10 years.

Apart from buying and owning that house, you can rent it out too. You still own it, but by renting it out, you get some monthly cashflow. This is your rental income. The income is still a "profit" to you. So after 10 years, if you rent out your house, you get returns in the form of capital gain (price appreciation of your house), and rental income over the 10-year period.

Same goes to stock, you buy Microsoft's or Apple's shares, their prices go up over the long run, like your house. Microsoft and Apple pay dividends. That is also part of the profit (like your rental income). But Microsoft and Apple don't distribute all their profits as dividends (they retain some for capital working and investment purposes). So a portion of the profits are retained with the companies. The rest distributed as dividends.

As the years go by, profits grow, and some goes into dividends to you, and some is retained by the company for further investment, and even more profit is generated from those investment, and thus the stock price rises. Thus compounding arises because the profits earned by the company is used to generate future revenue stream/profits on top of the profits earned early. The share price rises automatically as the market (the buyers and sellers) will factor in the rise in profits.

Simple example. You invest 100 dollars in company A at the beginning of year 1. Company A earns 5% per annum (p.a.). Your capital now becomes 105 dollars. Company A does not plan to declare any dividend at the end of year 1 but instead use your money to invest in some projects that generate 5% return p.a. So after another year, (end of years 2) your money is 105*1.05 = 110.25. I can rewrite this as (100+5)*(1.05) = 110.25.

So 2 components of return, your capital of 100 dollars is generating 5% p.a. in the second year 100*1.05 = 105, but so is the 5 dollars you earn in year 1, that gives you 5*1.05 = 5.25. The 5.25 dollars is the compounded return earned from reinvestment of profits a year earlier. (Imagine doing this for 10 years. This is how compounding arises) In this case, the company does it for you, internally.

Alternatively, the company could also distribute the profit of 5 dollars at the end of year 1 to you, but then to let compounding interest to work, you will need to reinvest the 5 dollars into the company yourself. In this case you reinvest the dividends by say, buying more shares of the same company. Both cases lead to compounding via reinvestment of profits, just different methodologies.

You asked for actual case, so here you go: compounding at work for Microsoft shares since inception in the late 80s.



2 lines appear in the graphs. The upper one which gives 395958.04% as the terminal value is the total return, while the bottom one whose terminal value is 252005.42% is the price return. The difference between the two is the dividend return (current income) over time. The astronomical numbers should demonstrate compounding at work, I hope.

An important point to note is compounding is generally a long term process, prices might go up and down because market sentiment changes every second. News, good or bad, appear every now and then. Profits fluctuate throughout the business cycle, but in the long run the trend is up, especially for blue-chip companies. Same applies for funds too, in general.

This post has been edited by TOS: May 18 2021, 10:54 PM

1. When there is no dividend, then only capital gain/loss. This is correct. No current income.

Like if you purchase a house but don't rent it out. After say 10 years, you decide to sell your house, your only returns will be the price appreciation of the house. Hence only capital gain. Same applies to stock.

2. No, There is still compounding effect from the rise in stock price. Notice the case for Microsoft's chart. The price return is still going up in the long-run. If companies elect not to declare dividends then the profits from the company will stay with the company. The money is still there. Companies will use the profits earned to invest further to generate even more revenue and profits.

So the profits still compound and grow every year. This is reflected in the stock price. Just because no dividends go to your pocket does not mean no compounding is at work. Otherwise, ask yourself, what will happen to the profits? It must go somewhere, right?

Some, and quite many companies declare little or no dividend at all. These companies are generally companies that are at their growth phase and need intensive capital investment, so the company's management choose to reinvest all the earnings/profits to further boost their profits in years to come. But compounding is still there, as profits grow exponentially. So share price rises. That is compounding at work.

This post has been edited by TOS: May 18 2021, 11:16 PM

Exactly. Compounding refers to interest on (previous) interest, returns on (previous) returns.



This post has been edited by TOS: May 18 2021, 11:34 PM

In theory you do.

The appreciation of SGD against MYR (currency), the fact that your feel safer parking your money there (credit risk), is the "interest" that the market prices in.

The lower interest rates of SGD deposits against that of MYR is the price one has to pay to compensate for the lower credit risk and other factor in SG (relative to MY).

Once again, the old adage: There is no free lunch in this world. There might be one occasionally, but arbitrage will ensure things remain balanced. Risk-return tradeoff is always true.

I would also suggest you to read up some academic finance and economics book, uni textbooks preferably. Have a good understanding of finance and economics will be of great help to you in understanding how the financial markets function.

At least you can think independently and not follow the herd. Investing is one thing to practice, but without understanding the underlying theory your portfolio won't go anywhere. For example, why S&P 500 is recommended instead of stock/portfolio picking etc. There are reasons behind these.

taiping...

The books proposed by Ram are also fine. Maybe read them first to have a rough idea then followed by the academic books I mentioned earlier, for starters this may be a better way of learning financial management. At least the slope won't be that steep.