How does compound interest work with investing eg accumulation funds?

22225

Sorry if this has been answered before. I keep reading how great compounding is over the long term etc. I understand this in relation to savings interest (good) and in terms of the fees on investing compounding (in a negative way) but how does compounding help in terms of where you invest in a fund eg an accumulation fund. Surely it's just the value of the fund that goes up or down but it doesnt compound? Maybe I don't understand the accumulation side of it. I thought that just meant if I bought the fund at say £50 a month every month and some months the price had gone down, the money I was paying would just buy more funds? What am I missing??? 

I have googled but I still can't see it. Can anyone explain as if to an idiot. I keep reading about compounding and investing but I don't see the link. Many thanks.

Killmark

When you invest in an accumulation fund, your returns are reinvested back into the fund rather than being paid out to you as dividends. Over time, these reinvested returns can generate additional growth because they become part of the total fund value, which in turn can earn further returns. This process of reinvesting returns and generating more returns on those reinvested amounts is what's known as compounding.

Here's an example:
Say you invest £50 in a fund and it grows by 5% over the year. At the end of the year, your investment is now worth £52.50. If the fund continues to grow by 5% in the following year, you're not just earning 5% on your initial £50, but on the £52.50, including the returns from the previous year. Over time, this compounding effect can significantly increase the value of your investment.

Sea_Shell

I think it works like this...

Imagine you bought an ACC fund/share which was priced at 215p per unit.   For your £50, you'd get 23.25 units.

Over the course of the year, that fund price increased to 225.75p, so up 5%.   Your investment is now worth £52.50

Some of that growth will be because returns have been reinvested, and some will be the general rise in the fund price.

I think you can work out the difference if you compare the ACC fund with its INC alternative.

The INC version, may only be up, say 2%, to 219.3p, but it's paid out the other 6.45p, as income.


That is your "compounded interest".

kimwp

22225 said:

Sorry if this has been answered before. I keep reading how great compounding is over the long term etc. I understand this in relation to savings interest (good) and in terms of the fees on investing compounding (in a negative way) but how does compounding help in terms of where you invest in a fund eg an accumulation fund. Surely it's just the value of the fund that goes up or down but it doesnt compound? Maybe I don't understand the accumulation side of it. I thought that just meant if I bought the fund at say £50 a month every month and some months the price had gone down, the money I was paying would just buy more funds? What am I missing??? 

I have googled but I still can't see it. Can anyone explain as if to an idiot. I keep reading about compounding and investing but I don't see the link. Many thanks.

The money you pay in each month isn't the compounding. Compounding is the money that your invested money makes also making money.

boingy

Some of the holdings inside the fund pay dividends and those dividends are reinvested in the fund rather than being paid to you directly.

Kaizen917

I think the compounding process can be tricky for accumulating funds because its hard to spot its inner workings to a large extent. For instance, we tend to think of the number of units themselves compounding so if you save GBP 1000 at 5% and end up with 1050 to leave for next year, one clearly sees how in the next year they expect interest on a bigger amount(i.e. each pound being our unit). Similar process might happen with income funds as dividents are clearly separated from the invested amount so if one is to manually reinvest the divident into the same income fund, they will end up with more share units and therefore up for a bigger divident in future.

Accumulating funds however, will keep same number of units but by reinvesting it would increase the share price (so it will be higher than the income version) and so the divident per unit will be bigger in the next divident distribution. I heard people may struggle, if they invested in acc funds outside of an ISA/SIPP, and couldnt figure out the precise amount of divident income they should declare. I know Vanguard tends to declare income per share of funds but my workplace pension or InvestEngine ISA dont so Im with a mixed feeling if I see numbers go up but not knowing why and how.

In practice, whether you use acc or inc funds but immediately reinvested, you should be about equally well off.At least this is my take on it, if that helps. Of course its possible I missed out or wrongly described something but I have no issue if someone from the community calls me out on it to correct me.

EthicsGradient

There was a thread on this a couple of years ago - answers there may help: https://forums.moneysavingexpert.com/discussion/6326925/how-does-compound-interest-work-on-accumulation-funds

Floyd_Pink

22225 said:

Sorry if this has been answered before. I keep reading how great compounding is over the long term etc. I understand this in relation to savings interest (good) and in terms of the fees on investing compounding (in a negative way) but how does compounding help in terms of where you invest in a fund eg an accumulation fund. Surely it's just the value of the fund that goes up or down but it doesnt compound? Maybe I don't understand the accumulation side of it. I thought that just meant if I bought the fund at say £50 a month every month and some months the price had gone down, the money I was paying would just buy more funds? What am I missing??? 

I have googled but I still can't see it. Can anyone explain as if to an idiot. I keep reading about compounding and investing but I don't see the link. Many thanks.

Warren Buffet explains it here-

https://www.youtube.com/watch?v=wBcGTc4MPG0

Bravepants

Don't forget though that not all the profit that a company makes is distributed as dividends. Many companies use profits to grow the business, which would increase the share value in the future. This could also be considered compounding.

22225

Ok thank you everyone. I didnt realise anything you said as in, this us new info for me. I thought investing in funds was like buying a bottle of wine for £10 and if after a year its value has gone up to £12.50, that's how you make your money, as long as you sell it at that higher price. 

So if I have a cheap global tracker it still gets dividends which the company automatically reinvests? Thank you

Altior

It's both isn't it. Below is a performance chart for an ETF that I invest in. There is a tick box to toggle Including dividends off/on. So it can easily be seen the difference when dividend compounding is included.

As others have said, there is internalised compounding as well, where profits are reinvested or there's share buybacks. It's all essentially the same mixing pot, invested capital gains profits over time, that profit adds to the total capital pie, therefore you start to get capital gain from previous capital gains as well as the original investment. 

Invesco FTSE RAFI All World 3000 UCITS ETF | PSRW | IE00B23LNQ02 (justetf.com)