How does compound interest work with index trackers?

waveydavey48

I've been trying to educate myself a little about investing and one common theme is the "miracle of compound interest" ie earning interest on your interest. I suppose with equities that means re-investing your share dividends.

I've started paying a modest amount into Vanguard's lifestrategy 80/20 fund via an ISA. Would anyone be kind enough to explain how compound interest works with that?

Thank you.

Bravepants

If the fund you have chosen is an Accumulation fund then the income, in the form of dividends from shares and fixed interest from bonds is automatically re-invested and the result is an increase in the price of the units.


If the fund is an Income version then you have the choice of taking the income (monthly, annually etc.) and withdrawing it, or re-investing it by buying more units.


If you re-invest the income, it generates more income, which is then re-invested, which generates more income and so on and so forth...thus compounding.


Funds of course also grow in capital value because the underlying shares rise in price with demand or with increased performance of the underlying company or organisation. The latter isn't really compounding, but the growth in capital value due to this PLUS the effect of adding in the income is called "total return".

bostonerimus

Funds grow in a couple of ways....their price increases (hopefully) as the stocks and/or bonds they hold go up in value and the total number of shares you own goes up as you reinvest dividends. The combination of those will be reported as a percentage annual return which is then often average over a number of years to show the long term performance.

Dox

waveydavey48 wrote: »

I've been trying to educate myself a little about investing and one common theme is the "miracle of compound interest" ie earning interest on your interest. I suppose with equities that means re-investing your share dividends.

I've started paying a modest amount into Vanguard's lifestrategy 80/20 fund via an ISA. Would anyone be kind enough to explain how compound interest works with that?

The simple answer is that it doesn't, if you use the strict definition of compound interest:

'Compound interest is the addition of interest to the principal sum of a loan or deposit, or in other words, interest on interest. It is the result of reinvesting interest, rather than paying it out, so that interest in the next period is then earned on the principal sum plus previously accumulated interest.'

Tracker funds can go down as well as up, and (depending on the index being tracked) don't usually earn interest. Increases in value come from increases in share price and retaining dividends within the fund (by reinvesting them to buy more units in the tracker fund).