How Compounding Works in Different Investment Vehicles

The principle of compounding is universal in the investing world, contributing to wealth creation across various types of investments. Below, we will explore how compounding works in different investment vehicles like stocks, bonds, and mutual funds.

  • Stocks: Compounding in stocks occurs when you reinvest the dividends received or when the price of the stock increases. For example, if you own 100 shares of a company that pays a $1 annual dividend, you will receive $100 the first year. If you reinvest this money by purchasing more shares, next year, you’ll earn dividends on the original 100 shares plus the additional shares you bought with your dividends.
  • Bonds: For bonds, compounding occurs when the interest earned on the bond is reinvested to purchase more bonds. Consider a bond that pays a 5% annual interest. If you own a $1000 bond, you’ll receive $50 in interest in the first year. If you reinvest this interest by buying more bonds, you will earn interest on the original $1000 plus the $50 interest you reinvested, totaling $1050. This process can continue year after year.
  • Mutual Funds: Compounding in mutual funds works similarly to stocks and bonds, where any dividends or capital gains are reinvested to purchase more units of the fund. Suppose you invest $10,000 in a mutual fund, and after one year, your investment grows to $11,000. If you leave your money in the fund, your $11,000 is now invested, and any returns in the following year will be calculated on this new amount.

In summary, regardless of the investment vehicle, the principle of compounding works the same: earning returns on your returns. This powerful concept is the key reason why even modest investments can grow substantially over time. The key is to start early, be consistent, and let the power of compounding do the heavy lifting.