How does compound interest actually work on investments?

eskbanker

IAMIAM said:

Thanks for this. Just so I can have a browse, any recommendations on what current 500 trackers that are out there? 

The S&P 500 was mentioned above as an example of an index that's done well in recent times, but that doesn't mean that it's a good idea to buy into it, except as a constituent of a broader portfolio designed with your objectives and risk tolerance in mind.  If you feel that browsing S&P 500 trackers is an appropriate thing to do, but without knowing where to find them, I'd humbly suggest that it would be counterproductive until you've researched the fundamentals of investing, rather than jumping several steps ahead....

thor

IAMIAM said:

Am I right in thinking its just shares, funds and bonds etc that are just increasing or decreasing in value, hence I don't understand where the compounding is happening? If something is £2 now and £20 in 10 years, the value of that £2 coin has gone up but where is the compound bit. 

Isn't compound interest a savings thing? It doesn't apply to investments which generate dividends and growth rather than interest I would have thought.

payless

It’s easier to see the impact with interest being added, but in reality also works with investments.

for example if stock market grew 10% for past two years ..  ( any divs reinvested) 

I invested £100  2 yrs ago , I would have  £121. ( £100, plus £10, plus £11)

Investment(1+r)(1+r)………

IAMIAM

If I were to invest £5k per year into a LISA until age 50 approx 15 years (then collect at age 60, so 25 years) with returns of circa 10% per annum, what would I be expecting at age 60?

payless

Does depend on when in the year you invest / withdraw, but using some common situations £446k

( used a website not manually checked, but looks in the ballpark, if indeed constant +10% was achievable  ! ) 

IAMIAM

Great, I am set on depositing £5k into a LISA per year at the start of each tax year for the next 15 years and potentially £5k into a S&S ISA too (ultimately saving £9k per year)

NedS

thor said:

IAMIAM said:

Am I right in thinking its just shares, funds and bonds etc that are just increasing or decreasing in value, hence I don't understand where the compounding is happening? If something is £2 now and £20 in 10 years, the value of that £2 coin has gone up but where is the compound bit. 

Isn't compound interest a savings thing? It doesn't apply to investments which generate dividends and growth rather than interest I would have thought.

Compounding applies to any investment gains (or losses) which are not realised (withdrawn) at the time. It's probably just easiest explained with a simple savings model yielding a percentage interest.
With shares in a company, it's far more opaque. When that company makes a profit, they choose what to do with that profit - they could pay it out to investors in the form of a dividend (a bit like interest) which you may choose to reinvest in more shares (compounding), or they could engage in share buybacks raising the value of your shares, or they could invest that money in the company to increase future profits. Whichever route the company takes, they are all designed to increase the value of your initial investment, compounding the the effects of those profits over time.

jimjames

thor said:

IAMIAM said:

Am I right in thinking its just shares, funds and bonds etc that are just increasing or decreasing in value, hence I don't understand where the compounding is happening? If something is £2 now and £20 in 10 years, the value of that £2 coin has gone up but where is the compound bit. 

Isn't compound interest a savings thing? It doesn't apply to investments which generate dividends and growth rather than interest I would have thought.

Not really. If something grows 10% one year, 5% the next and so on then that's all compounding too. Obviously most investments do not pay interest, some pay dividends but regardless they still compound over time.

Thrugelmir

NedS said:

thor said:

IAMIAM said:

Am I right in thinking its just shares, funds and bonds etc that are just increasing or decreasing in value, hence I don't understand where the compounding is happening? If something is £2 now and £20 in 10 years, the value of that £2 coin has gone up but where is the compound bit. 

Isn't compound interest a savings thing? It doesn't apply to investments which generate dividends and growth rather than interest I would have thought.

Compounding applies to any investment gains (or losses) which are not realised (withdrawn) at the time. It's probably just easiest explained with a simple savings model yielding a percentage interest.
With shares in a company, it's far more opaque. When that company makes a profit, they choose what to do with that profit - they could pay it out to investors in the form of a dividend (a bit like interest) which you may choose to reinvest in more shares (compounding), or they could engage in share buybacks raising the value of your shares, or they could invest that money in the company to increase future profits. Whichever route the company takes, they are all designed to increase the value of your initial investment, compounding the the effects of those profits over time.

Share prices can fluctuate depending on the demand for the stock without any direct correlation to underlying profitability of the business.

Simply extrapolating future returns on the basis of recent years is at the least unwise. The world of commerce isn't that predictable. 

eskbanker

IAMIAM said:

If I were to invest £5k per year into a LISA until age 50 approx 15 years (then collect at age 60, so 25 years) with returns of circa 10% per annum, what would I be expecting at age 60?

A reality check?