Author Topic: In what sense do stock gains "compound"?  (Read 13553 times)

blub

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In what sense do stock gains "compound"?
« on: March 31, 2014, 08:09:58 PM »
I've seen, in several places, mentions of stock gains compounding. I can see how reinvesting dividends would result in some degree of compounding, but not regular stock gains. Am I missing some aspect of this? Is it simply an abuse of the word "compound"?

For a specific instance, there is mention on http://www.mrmoneymustache.com/2012/05/14/first-retire-then-get-rich/ of "[compounding] at 5% after inflation". Sounds great to me, but does such an investment really exist?

Ohio Teacher

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Re: In what sense do stock gains "compound"?
« Reply #1 on: March 31, 2014, 08:20:24 PM »
Your gains make gains.  That is compounding.  For a simple example, if you make 5% on $1000 the first year, you have $1050.  If you make 5% on the $1050 the second year, you now have $1102.50.  So, you made an extra $2.50 the second year due to compounding.

AlmstRtrd

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Re: In what sense do stock gains "compound"?
« Reply #2 on: March 31, 2014, 08:43:59 PM »
I am with blub here. The only way that "stock gains compound" is through reinvested dividends, no? Right now the yield on the S&P 500 is at 1.87% (if the figure I pulled up today is correct). The rest of the gains in stocks would have to come from the assumed increase in their price. The current S&P yield, incidentally, is quite low by historical standards but probably not very low in relation to interest rates (meaning that it's one of the places folks put cash to avoid not making anything). But I digress. At 1.87% you'd need about 38 years to double your money. Better than nothing but not something to get too excited about, especially inasmuch as we are only talking about a nominal doubling.

dragoncar

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Re: In what sense do stock gains "compound"?
« Reply #3 on: March 31, 2014, 09:12:57 PM »
It's just another way of saying that stock price growth is exponential, not linear.

sol

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Re: In what sense do stock gains "compound"?
« Reply #4 on: March 31, 2014, 09:14:12 PM »
Yes, most of the compounding is in the asset price.

Over the long term, the stock market does not return a fixed amount of profit per year.  Instead, the stock price grows (on average) by a few percent a year.  This year you made 5% on your $100 of stock and now have $105.  Next year you're not going to make another $5, you're going to make another 5%, or $5.25.  Decades later when your stock is worth $3000, you're still going to be earning 5% per year ($150) instead of still earning the $5 you made the first year.  Most of the compounding is in the stock price.

Reinvested dividends just speed up the process.  The dividend gain still shows up in the total value of the stock you own, so you have to sell it to claim your gains either way.

iamlindoro

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Re: In what sense do stock gains "compound"?
« Reply #5 on: March 31, 2014, 09:18:29 PM »
I am with blub here. The only way that "stock gains compound" is through reinvested dividends, no?

No, for the reason explained above.  A percentage is a percentage is a percentage.  The US market has historically increased at an annual rate of 8-11%, not including dividends.  Consider you invest $1000 on day one, and add nothing further.  The assumption is that future returns are in line with the all time average.  So, at the beginning of each of the following ten years, you would have...

Year 1 - $1000
Year 2 - $1080
Year 3 - $1166
Year 4 - $1260
Year 5 - $1360
Year 6 - $1469
Year 7 - $1586
Year 8 - $1713
Year 9 - $1850
Year 10 - $2159

And you've more than doubled your money in 10 years at 8%.  That's compounding, and that's with 0 dividends.

Cwadda

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Re: In what sense do stock gains "compound"?
« Reply #6 on: March 31, 2014, 09:28:02 PM »
I am with blub here. The only way that "stock gains compound" is through reinvested dividends, no?

No, for the reason explained above.  A percentage is a percentage is a percentage.  The US market has historically increased at an annual rate of 8-11%, not including dividends.  Consider you invest $1000 on day one, and add nothing further.  The assumption is that future returns are in line with the all time average.  So, at the beginning of each of the following ten years, you would have...

Year 1 - $1000
Year 2 - $1080
Year 3 - $1166
Year 4 - $1260
Year 5 - $1360
Year 6 - $1469
Year 7 - $1586
Year 8 - $1713
Year 9 - $1850
Year 10 - $2159

And you've more than doubled your money in 10 years at 8%.  That's compounding, and that's with 0 dividends.

Exactly.

Play with this for a while, too. https://www.investor.gov/tools/calculators/compound-interest-calculator

AlmstRtrd

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Re: In what sense do stock gains "compound"?
« Reply #7 on: March 31, 2014, 09:30:31 PM »
Got it. Thanks. Gains on gains with or without dividends. I think I learned that with my passbook savings account when I was 10 but for some reason I never thought of the stock market that way. Little slow. Thanks.

blub

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Re: In what sense do stock gains "compound"?
« Reply #8 on: March 31, 2014, 09:52:31 PM »
It's just another way of saying that stock price growth is exponential, not linear.

Thanks, this helps. It's surprising that stock price growth would be exponential, though. Is it the exception or the rule? Is there any convincing reason to explain it or empirical evidence?

dragoncar

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Re: In what sense do stock gains "compound"?
« Reply #9 on: March 31, 2014, 10:01:02 PM »
It's just another way of saying that stock price growth is exponential, not linear.

Thanks, this helps. It's surprising that stock price growth would be exponential, though. Is it the exception or the rule? Is there any convincing reason to explain it or empirical evidence?

I'd say it's an empirical observation, not a "rule".  Probably related to population growth, which is also exponential (and of course neither should be blindly extrapolated into the future).  It's a good question, and I kinda wish I could summon Jacob from ERE to come explain it to us.

MDM

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Re: In what sense do stock gains "compound"?
« Reply #10 on: March 31, 2014, 10:42:23 PM »
Yes, there is no rule that says stock values have to increase exponentially.  Historically, however, they do.

See charts below, with values of the S&P 500 index from Jan. 1957 to Mar. 2014.  The top shows a linear fit, the bottom an exponential fit.

Although exponential is a "good" way to fit this data (at least, better than linear), for the past ~20 years one could say that the curve intersects the data only coincidentally.  Just another way of noting that, given time, the market will increase - but there can be a lot of downs with the ups along the way.



marty998

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Re: In what sense do stock gains "compound"?
« Reply #11 on: April 01, 2014, 02:12:10 AM »
It's just another way of saying that stock price growth is exponential, not linear.

Thanks, this helps. It's surprising that stock price growth would be exponential, though. Is it the exception or the rule? Is there any convincing reason to explain it or empirical evidence?

It's not exponential if you own the stocks I do. I start with some and end up with smaller than some.

msilenus

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Re: In what sense do stock gains "compound"?
« Reply #12 on: April 01, 2014, 02:14:22 AM »
It's exponential because companies, like debt instruments bring in money.  They do one of two things with their earnings:
1) Return it to investors, usually as dividends.
2) Reinvest them in expansion and growth.

Those are both forms of compounding.  The second internally within the company, and the first possibly externally, when you invest it elsewhere.  They both drive exponential curves.

nereo

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Re: In what sense do stock gains "compound"?
« Reply #13 on: April 01, 2014, 06:32:07 AM »
Thanks, this helps. It's surprising that stock price growth would be exponential, though. Is it the exception or the rule? Is there any convincing reason to explain it or empirical evidence?
The stock market is made up of companies that sell goods and services to people.  If they can sell more G&S to more people at a profit, they will become more profitable and their share price and/or dividend will increase.

To understand it from a very, very big-picture perspective, think about the entire global market to produce and sell goods and services.
First, the global population is increasing. Overall, that means more people who can work, and who also need things.
Second, the standard of living is increasing at a global level, and there is a LOT of room left for people's lives to improve: about 99% of the world's families live on <$35,000 per year, and more than half live on less than $3000.
Third, technology has allowed us to produce more with less work. This is most obvious in manufacturing, where automated assembly lines allow a factory to produce more goods in less time with fewer workers.
Finally, advances in distribution mean that these goods and services can get to markets with less wasted.  For example, grain can be shipped to far away ports and trucked hundreds of miles inland to areas that need it (provided they can pay for it).

So, put that all together and you have a growing population that is getting richer on a whole and can produce more with less work and less waste.

That, in a nutshell, is why the stock market can go up 8-11% a year on average.

AlmstRtrd

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Re: In what sense do stock gains "compound"?
« Reply #14 on: April 01, 2014, 08:14:13 AM »
I guess I am more pessimistic about the reliability of stock returns than most people on this forum. If you look at a graph like the "exponential" one above that only goes through the end of 2008, that climb is WAY less steep. When an asset (stocks, bonds, real estate) is at an all-time high, it's fairly easy to make or find a graph that seems to confirm a predictable upward trend. I look at the last 13-14 years of the S&P graph and think, man, that 20-30% or so return (without dividends) over 13-14 years is not very good considering all that volatility. And I understand that anyone who is able to DCA in will have done better. Haven't seen a similar graph for long-term US treasuries for the last 20 years but I imagine that would look awfully good as well.

Could be that my perspective is shifting as well as I get older. There are just a lot of older folks who got crushed in the early 2000s and/or 2008 who were not able to hold on and let their assets recoup their losses.

matchewed

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Re: In what sense do stock gains "compound"?
« Reply #15 on: April 01, 2014, 08:19:18 AM »
I guess I am more pessimistic about the reliability of stock returns than most people on this forum. If you look at a graph like the "exponential" one above that only goes through the end of 2008, that climb is WAY less steep. When an asset (stocks, bonds, real estate) is at an all-time high, it's fairly easy to make or find a graph that seems to confirm a predictable upward trend. I look at the last 13-14 years of the S&P graph and think, man, that 20-30% or so return (without dividends) over 13-14 years is not very good considering all that volatility. And I understand that anyone who is able to DCA in will have done better. Haven't seen a similar graph for long-term US treasuries for the last 20 years but I imagine that would look awfully good as well.

Could be that my perspective is shifting as well as I get older. There are just a lot of older folks who got crushed in the early 2000s and/or 2008 who were not able to hold on and let their assets recoup their losses.

Not just a perspective thing of age but of timescale. You're looking at it from 10-20 year timescales. Expand that to 60 year timescales and you have a more realistic perspective of growth.

FrenchyMustache

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Re: In what sense do stock gains "compound"?
« Reply #16 on: April 01, 2014, 08:39:13 AM »
Ok, i may be dumb aswell, but lets say you have start with an asset of 1000
And lets say in your first year of investment, your asset got a drop of 25% (Thats really pessimistic, i know) i your asset, then the regular compounding beggins, of 8% for example.
Is the following right ?:

Year 1 - 1000 // CRASH 25%
Year 2 - 700
Year 3 - 756
Year 4 - 816.48
Year 5 - 881.76
Year 6 - 952.33
Year 7 - 1028.51
Year 8 - 1110.79
Year 9 - 1199.65
Year 10 - 1295.62

Well ... I was willing to make a point where a crash market would kick out the compounding itself and/or the asset bit,  but after making the math myself, you still finish with around 3% of avarage return on your asset... Why is it so hard for me to believe that ? I have always have this strange fear about the stock thingy, is this like a crowd mind-thing in the Usa aswell ?

DoctorOctagon

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Re: In what sense do stock gains "compound"?
« Reply #17 on: April 01, 2014, 08:50:20 AM »
You guys make this too complicated.

Compounding: Each year returns 10% more than the previous year. 

Year 1 - principal stock value (original purchase price)
Year 2 - value 1.1 (year 1 x 1.1)
Year 3 - value 1.21 (year 2 x 1.1)
Year 4 - value 1.331 (year 3 x 1.1)
Year 5 - value 1.4641 (year 4 x 1.1)
Year 6 - value 1.61051 (year 5 x 1.1)
Another way to write it would be Principal x (1.10 ^ years invested)



Linear: Each year returns 10% of the original investment.

Year 1 - principal stock value (original purchase price)
Year 2 - value 1.1 (Add 10% of principal, or .1, to last year's value)
Year 3 - value 1.2 (Add 10% of principal, or .1, to last year's value)
Year 4 - value 1.3 (Add 10% of principal, or .1, to last year's value)
Year 5 - value 1.4 (Add 10% of principal, or .1, to last year's value)
Year 6 - value 1.5 (Add 10% of principal, or .1, to last year's value)

See how after 6 years the compound growth of 10% results in a value of 1.61051, while linear growth results in 1.5?

kyleaaa

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Re: In what sense do stock gains "compound"?
« Reply #18 on: April 01, 2014, 08:55:10 AM »
If I buy a stock at $100 per share and it goes to $110 per share at the end of year one, I just earned a 10% rate of return, right? Well, if NEXT year the stock goes up 10% again, I end up with a share worth $121. That 10% gain was worth $11 this year and not just $10. Why? Compounding.

Stock growth is exponential, not linear. And yes, there are hundreds of years of empirical evidence for this.
« Last Edit: April 01, 2014, 08:57:08 AM by kyleaaa »

warfreak2

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Re: In what sense do stock gains "compound"?
« Reply #19 on: April 01, 2014, 09:00:28 AM »
If you look at a graph like the "exponential" one above that only goes through the end of 2008, that climb is WAY less steep.
Yes, because a chart that shows exponential growth on an absolute scale is going to over-represent recent volatility. A swing of 5% in 1960 is going to look trivial compared to a swing of 5% in 2010, though the effect on your investment would be the same.

Here's a logarithmic graph which is a lot more representative:
https://upload.wikimedia.org/wikipedia/en/3/38/Daily_Log_Chart_of_S%26P_500_from_1950_to_2013.png

AlmstRtrd

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Re: In what sense do stock gains "compound"?
« Reply #20 on: April 01, 2014, 09:24:29 AM »
Not questioning the compounding at this point in the thread... just the optimism related to future stock growth. See Frenchy's post above for a good illustration why. Stocks can stay down for really long periods and at age 55 I don't have a 60-year investment horizon.

arebelspy

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Re: In what sense do stock gains "compound"?
« Reply #21 on: April 01, 2014, 09:24:47 AM »
Ok, i may be dumb aswell, but lets say you have start with an asset of 1000
And lets say in your first year of investment, your asset got a drop of 25% (Thats really pessimistic, i know) i your asset, then the regular compounding beggins, of 8% for example.
Is the following right ?:

Year 1 - 1000 // CRASH 25%
Year 2 - 700
Year 3 - 756
Year 4 - 816.48
Year 5 - 881.76
Year 6 - 952.33
Year 7 - 1028.51
Year 8 - 1110.79
Year 9 - 1199.65
Year 10 - 1295.62

Well ... I was willing to make a point where a crash market would kick out the compounding itself and/or the asset bit,  but after making the math myself, you still finish with around 3% of avarage return on your asset... Why is it so hard for me to believe that ? I have always have this strange fear about the stock thingy, is this like a crowd mind-thing in the Usa aswell ?

It's actually even better than you post.

A few errors with your math:
1) A 25% crash would leave you with 750, not 700.
2) You only did 9 years (from the start of year 1 to the start of year 10).  You should have the final end value of year 10 (aka start of year 11).

Changing those leaves us with:
Year 1 - 1000 // CRASH 25%
Year 2 - 750
Year 3 - 810
Year 4 - 874.80
Year 5 - 944.78
Year 6 - 1020.36
Year 7 - 1101.99
Year 8 - 1190.15
Year 9 - 1285.36
Year 10 - 1388.19
End of Year 10- 1499.25

Also you need to calculate a CAGR, not just divide the percent return by the number of years.  Your overall return after those 10 years of a 25% drop followed by 9 years of 8% returns would be an overall annual (CAGR) return of 4.13%.

Doing it the other way (8% returns for 9 years then dropping 25% in the last year) yields the same amount, 1499.25, BTW.

So a 25% drop and 8% returns the other years in a decade yields a 4.13% annualized return.
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AlmstRtrd

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Re: In what sense do stock gains "compound"?
« Reply #22 on: April 01, 2014, 09:34:25 AM »
Thanks for the re-do on the math, arebelspy. And for looking at the flipped scenario where the crash happens at the end.

Just came across these charts:

http://www.advisorperspectives.com/dshort/commentaries/SPX-Dow-Nasdaq-Since-Their-2000-Highs.php

Those are really sobering numbers. Ouch!

Again, my investment horizon is not as long as some others but I think a lot of what people expect from the stock market is based on what happened between 1982 and early 2000.

nereo

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Re: In what sense do stock gains "compound"?
« Reply #23 on: April 01, 2014, 09:51:26 AM »
Not questioning the compounding at this point in the thread... just the optimism related to future stock growth. See Frenchy's post above for a good illustration why. Stocks can stay down for really long periods and at age 55 I don't have a 60-year investment horizon.
This is where dividends become so important.  Often people look only at the stock price because it's easy to do.  Stock XXX trades at $100 today, it traded at $80 last year, therefore it increased 25%

Companies that pay dividends are loathe to reduce or eliminate them, and most large-cap have dividend payouts "baked in" to their business plan, much like R&D or marketing expenses.  In fact, in the SP500 have NEVER gone below 1%, and over the last 50 years have been around 3%.  Currently they are on the low end at about 1.9%.

You may ask "how much does this matter?"  Well, a lot. If you look at the returns of the SP500 over the last 60 years you get this (all adjusted for inflation):
Without dividends reinvested: 3.6% annualized return
WITH dividends reinvested: 6.9% annualized return.

Translating that into dollars, supposed you had $10,000 invested in the SP500 sixty years ago. 
Without dividends reinvested you would have about $60,000* 
With dividends reinvested you would have: $585,000

*plus dividend checks totaling approximately $45k over 60 years.  Your gross total would still be $105,000, as opposed to $585,000 with dividends reinvested.

nereo

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Re: In what sense do stock gains "compound"?
« Reply #24 on: April 01, 2014, 09:56:08 AM »
Ok, i may be dumb aswell, but lets say you have start with an asset of 1000
And lets say in your first year of investment, your asset got a drop of 25% (Thats really pessimistic, i know) i
I don't think -25% is all that pessimistic all at.  Historically, the SP500 has dropped at least 30% from some peak about every 8.5 years.  It falls 10% from a recent high (aka "a correction") about once every year.

matchewed

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Re: In what sense do stock gains "compound"?
« Reply #25 on: April 01, 2014, 10:02:24 AM »
Not questioning the compounding at this point in the thread... just the optimism related to future stock growth. See Frenchy's post above for a good illustration why. Stocks can stay down for really long periods and at age 55 I don't have a 60-year investment horizon.
This is where dividends become so important.  Often people look only at the stock price because it's easy to do.  Stock XXX trades at $100 today, it traded at $80 last year, therefore it increased 25%

Companies that pay dividends are loathe to reduce or eliminate them, and most large-cap have dividend payouts "baked in" to their business plan, much like R&D or marketing expenses.  In fact, in the SP500 have NEVER gone below 1%, and over the last 50 years have been around 3%.  Currently they are on the low end at about 1.9%.

You may ask "how much does this matter?"  Well, a lot. If you look at the returns of the SP500 over the last 60 years you get this (all adjusted for inflation):
Without dividends reinvested: 3.6% annualized return
WITH dividends reinvested: 6.9% annualized return.

Translating that into dollars, supposed you had $10,000 invested in the SP500 sixty years ago. 
Without dividends reinvested you would have about $60,000* 
With dividends reinvested you would have: $585,000

*plus dividend checks totaling approximately $45k over 60 years.  Your gross total would still be $105,000, as opposed to $585,000 with dividends reinvested.

I'd have to disagree, given AlmstRtrd's point about being older and much closer to retirement advocating to go into a few select dividend stocks rather than traditional equity/bond allocation for an average person in that position may be too much risk for someone concerned with crashes.

AlmstRtrd you have to understand that my comments on 60 year timelines is fairly representative of this board. Yes there are people outside of that but we take a rather long view on it. Given your age you are still looking at a 30-40 year timeline. If you are concerned about immediate risks such as a crash use http://www.cfiresim.com/input.php to run some models of various asset allocations; see how they would have fared in historical scenarios. And perhaps take a look at this video/transcript from Wade Pfau's site regarding a "barbell" like AA adjustment as you get closer to retirement to mitigate the concern you're expressing.

AlmstRtrd

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Re: In what sense do stock gains "compound"?
« Reply #26 on: April 01, 2014, 10:07:13 AM »
Thanks for the reminder on reinvested dividends, nereo. Do you have the figures for real returns including dividends since 2000?

And thanks for the links, matchewed. I will check them out later today. Gotta go work out to make sure I live a long time so we can still be discussing this stuff when I am 95!

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Re: In what sense do stock gains "compound"?
« Reply #27 on: April 01, 2014, 10:26:37 AM »
Quote
I'd have to disagree, given AlmstRtrd's point about being older and much closer to retirement advocating to go into a few select dividend stocks rather than traditional equity/bond allocation for an average person in that position may be too much risk for someone concerned with crashes.
Yes, sorry I didn't indicate that I wasn't talking about AlmstRtrd's specific circumstance of a more limited time-line there.  I was merely making the point that dividends are incredibly important when calculating returns, and you can never simply use stock price as a measure of growth.

Thanks for the reminder on reinvested dividends, nereo. Do you have the figures for real returns including dividends since 2000?
Sure.  Real-adjusted returns from Jan 2000 to March 2014 are a pretty dismal 1.3% with dividends reinvested.  2000 was a pretty high peak though.  If you choose other years between 1997 and 2004 you get annualized returns ranging from 1.3% (the lowest) to 6.9%

EDIT: I should mentionmy calculations are based off of Robert Shiller's publicly available data set, and these sets of handy calculators which utlitize this data set, found here: http://dqydj.net
« Last Edit: April 01, 2014, 10:29:22 AM by nereo »

arebelspy

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Re: In what sense do stock gains "compound"?
« Reply #28 on: April 01, 2014, 10:56:53 AM »
Real-adjusted returns from Jan 2000 to March 2014 are a pretty dismal 1.3% with dividends reinvested.

And keep in mind AlmstRtrd, that's shoving in all your money at the 2000 peak. 

You'd still have earned 1.3% above inflation and the 4% rule would be absolutely fine for a 30-year time span with that sort of return.

If you had put in money any time before or after that you'd have done better than that 1.3% real return.
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Re: In what sense do stock gains "compound"?
« Reply #29 on: April 01, 2014, 11:12:38 AM »

If you had put in money any time before or after that you'd have done better than that 1.3% real return.
... or dollar cost averaging (DCA), which is what the vast majority of people do in some form anyway, since almost everyone (at least on these boards) saves some money most years in IRAs, 401(k)s, general savings...
Eliminate the peaks, eliminate the valleys, reinvest the dividends and you get a ~6-7% return after inflation on virtually every time line longer than than 10 years.

FrenchyMustache

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Re: In what sense do stock gains "compound"?
« Reply #30 on: April 01, 2014, 11:30:47 AM »
Ok. Thanks for the correction, this stuff is brand new to myself.
So if i get all the stuff right.Each time you buy Index funds like SP500 (or why not CAC40 :rolleyes: )  you gotta watch for two things, the dividends you may receive, and the value of the asset itself.
Since, in the FIRE perspective of X years, are you going to sell at any point ? Since its all about how many stocks you hold and how much dividend you get per stock, should we just focus on a Number of stocks rather than a net worth ?

dragoncar

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Re: In what sense do stock gains "compound"?
« Reply #31 on: April 01, 2014, 11:41:36 AM »
why not CAC40

Well the CAC40 is only 40 companies, and the S&P500 is 500, for one.  I don't know anyone advocating DJIA either (which is 30 companies).

matchewed

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Re: In what sense do stock gains "compound"?
« Reply #32 on: April 01, 2014, 11:49:20 AM »
Ok. Thanks for the correction, this stuff is brand new to myself.
So if i get all the stuff right.Each time you buy Index funds like SP500 (or why not CAC40 :rolleyes: )  you gotta watch for two things, the dividends you may receive, and the value of the asset itself.
Since, in the FIRE perspective of X years, are you going to sell at any point ? Since its all about how many stocks you hold and how much dividend you get per stock, should we just focus on a Number of stocks rather than a net worth ?

You are much more likely to sell at some point. There are a few strategies which rely on dividends as the sole support for your income but it is a narrow strategy that may not be best. There are many more strategies which are about selling the stocks/bonds and living off of the sale.

Focus on the basics. Approximately 25 times your expenses and you have enough assets to FIRE given a 4% SWR and 8% returns (those returns being stock growth and dividends). That is the roughest rule out there. You notice it says nothing about the number of stocks. It is all about how much money you have, how much it grows, and how much you take out.

FrenchyMustache

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Re: In what sense do stock gains "compound"?
« Reply #33 on: April 01, 2014, 12:24:58 PM »
Yeah i said that because i'm still trying to guess my best bet on my index strategies around the sole French and / or European index. (I can put 150.000 in there and get tax-free on dividends as long as i hold 8 years min.)
But i'm guessing you guys have like 2 phases building strategies, one for growing the 'stash as fast as possible while avoiding as max as possible fees and the taxman and when it reached the 25*Spen, you switch on another strat', allowing you to live off the assets while regenrating the stash;

matchewed

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Re: In what sense do stock gains "compound"?
« Reply #34 on: April 01, 2014, 12:31:56 PM »
Yeah i said that because i'm still trying to guess my best bet on my index strategies around the sole French and / or European index. (I can put 150.000 in there and get tax-free on dividends as long as i hold 8 years min.)
But i'm guessing you guys have like 2 phases building strategies, one for growing the 'stash as fast as possible while avoiding as max as possible fees and the taxman and when it reached the 25*Spen, you switch on another strat', allowing you to live off the assets while regenrating the stash;

Sure there are various "phases" to your finances. Prior to FIRE you are in what is known as the accumulation phase, or <25 times your expenses. Once you get to that 25 (or 30 or whatever depending on your risk level) you are in a withdrawal phase.

During your accumulation phase you are focused on saving as much as you can. The investment strategy of that money you are saving just has to be inline with your values, risk tolerance, tax efficiency, and fee minimization. During your withdrawal phase you are withdrawing based on very similar criteria.

skyrefuge

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Re: In what sense do stock gains "compound"?
« Reply #35 on: April 01, 2014, 05:08:48 PM »
I can see how reinvesting dividends would result in some degree of compounding, but not regular stock gains. Am I missing some aspect of this? Is it simply an abuse of the word "compound"?

This bothered me for quite a while too, especially since lots of people repeat it with a hand wave, and I've never seen it explained in more detail. I think the main reason it's difficult to translate the traditional view of "compounding" into the world of stocks is because in the traditional view, the value of your principal never goes down. You take your interest from your savings account, slap it on top of your existing principal, and now you have more principal than you started with. That generates more interest than the last round did, rinse, repeat, and you have compounding. Great.

But in a stock investment, the value of your principal shoots around all over the place with no real rhyme or reason. If it does produce interest (dividends), then you can slap that on top of your principal in the same way, and maybe over the long term, that steady accumulation of shares will smooth out into something that looks like compounding (though you'll have to squint harder to see it there than in a savings account).

But in a stock that doesn't pay dividends? Sure, if you're lucky, the price chart may look like an exponential curve for a while, but that's just people speculating, and it could all come crashing down. There's no solidity under it, no base that you're continually cementing new globs of stone onto.

Many of the explanations in this thread also aren't gut-level satisfying to me. "it's compounding because I can look into the past and fit an exponential curve to it" is a very post-hoc explanation, and doesn't have the feeling of a predictive law; there's still no solidity there. Even the more explanatory attempt of "stocks grow exponentially because humans grow exponentially" feels far too theoretical and distant, and a million miles away from the explanation of why a savings account grows exponentially.

So the secret, I think, is to realize that stock prices don't actually shoot all over the place with no rhyme or reason. Yes, speculation, earthquakes on the other side of the world, and a million other things affect a stock, and often mask the "solid" part of a stock's price. But in most cases there is a solid base there underneath the outer layers of variable fluff. Over longer terms, that base becomes more important to determining the value of the stock, and the company can definitely increase the size of that base via compounding in a way that doesn't feel too far from a savings account (even if they don't pay dividends). Here's how:

Say RockCo sells pet rocks. They have 100 machines that make pet rocks. By selling all the rocks those machines make, they earn $100k in profit every year. If they wanted to, they could pay that $100k out to shareholders as a dividend every year. You, as an owner of 100 RockCo shares, could take that dividend, buy 10 more RockCo shares. The next year, your dividend from your 110 shares would be higher, and you'd be able to buy 11 more shares. And so on. Voila, compounding.

But what if they don't pay a dividend? Well, then they're doing something that they think is more valuable with that money. Most likely, they're buying new machines to make more pet rocks. Say that $100k in profit allows them to buy 10 more machines. With increased production capacity, the next year they make $110k in profit, and are able to buy 11 more machines. Then 12 more, then 14 more. Wait 10 years and they've got 260 machines and are adding a whopping 25 machines the next year, and dominating their industry.

That's compounding. Good, solid compounding. And the market recognizes it. It sees through the fluffy outer shell of the stock price, and sees the solid core of pet rock-making machines, and says "these machines have value, and their ability to produce pet rocks has value, and their ability to help the company buy more value-producing machines has value". Value that has built itself up exponentially over time, and won't go away when there's an earthquake on the other side of the world.

Not all companies use machines to make profits. Some use people, and some use the ideas generated by those people. But compounding with people and ideas works just the same as it does with machines and savings accounts.

At least, that's the story I tell myself to feel better about compounding. :-)

nereo

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Re: In what sense do stock gains "compound"?
« Reply #36 on: April 01, 2014, 06:17:49 PM »
Skyrefuge

You bring up a good point about stocks that don't pay a dividend, but I think your analysis misses something.  At it's very core, a stock price is a measure of how valuable a company is, and valuable you expect it to be in the near future.

So let's say you have your company, RockCo.  Sure, they could buy more machines to make more rocks to increase their profit.  OR... they could simply stockpile their net profits.  Following that strategy, the company would increase in value by $100k every year.  10 years down the road, they'd be worth $1M.  This is linear growth.  Exponential growth will occur if expand their sales and/or become more efficient.

A rising population (customer base) is only one driver of growth.  The other, and more arguably important drivers are increased efficiency and a general rise in the standards of living.

dragonstache

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Re: In what sense do stock gains "compound"?
« Reply #37 on: April 01, 2014, 10:24:24 PM »
I think efficiency, not only through improved technology, and more than exponential population growth, drives a lot of this. The way I always think about it is this: we humans are getting better and better at doing stuff. Period. We think of the Internet, we reorganize production and supply chain management to reduce shipping costs by 5%, another person gets educated in how to be a dentist, someone discovers a new cold fusion technique reducing fuel costs by 3%. That guy who got trained to be a dentist learned all the dentistry knowledge of the past 2000+ years but added some small new surgical technique. Looking at it in terms of population growth makes it seem like we're going to run out of stuff, and looking at in terms of technology alone I think makes one look for big (disruptive) wins, instead of incremental. I think that even of we achieved some sort or "stable" population level we'd still achieve compounding economic gains due to our ability to just do stuff better and more efficiently. People are pretty smart and pretty awesome, and a lot of 5%s all over the place add up quickly. I think this is essentially a "cornucopian" view, or so I've heard it called before.

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Re: In what sense do stock gains "compound"?
« Reply #38 on: April 01, 2014, 11:35:53 PM »
Many of the explanations in this thread also aren't gut-level satisfying to me. "it's compounding because I can look into the past and fit an exponential curve to it" is a very post-hoc explanation, and doesn't have the feeling of a predictive law; there's still no solidity there.

Yep, past results are most definitely not a guarantee of future performance.  There is no predictive law, based on fundamental science, here at all.  Perhaps somewhat disconcerting to anyone who is used to analyzing more deterministic systems, but so it goes.

The best we all have is "reason to believe", based on a hundred years or so of recent history, that the performance of large groups of stocks is statistically predictable over long time periods.  And the best fits to that past data show exponential growth.  But that's as solid as it gets - up to everyone to decide for themselves what to trust. 

skyrefuge

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Re: In what sense do stock gains "compound"?
« Reply #39 on: April 02, 2014, 11:36:51 AM »
So let's say you have your company, RockCo.  Sure, they could buy more machines to make more rocks to increase their profit.  OR... they could simply stockpile their net profits.  Following that strategy, the company would increase in value by $100k every year.  10 years down the road, they'd be worth $1M.  This is linear growth.  Exponential growth will occur if expand their sales and/or become more efficient.

Well, no, I would hope that they would at least stockpile their profits in a savings account that returned some interest. Then, boom, we're right back to compounding and exponential growth.

My point is twofold:

1) Compounding requires real, money-producing assets. Those assets can be cash in a savings account, machines in a factory, or a bunch of other stuff. "Increasing efficiency" or "a rising living standard" are not assets, so they cannot compound (they can certainly affect the rate at which your assets compound, however).

2) The real, money-producing assets held by a company affect its stock price, and that is how stocks can compound.

Yep, past results are most definitely not a guarantee of future performance.  There is no predictive law, based on fundamental science, here at all.  Perhaps somewhat disconcerting to anyone who is used to analyzing more deterministic systems, but so it goes.

Right, and I think that's why it's confusing when financial writers (including MMM) use the word "compounding" to refer to stock market returns. Because, IMO, it's a misapplication of the term.

I believe when most readers (especially new investors) read "Over a ten year period, that money will compound at 7%", their immediate reaction is to think of compound interest in a savings account. Then they say "but where the heck can I get a savings account paying a 7% interest rate?!" The answer is "the stock market". Except, then the reaction is "wait, the stock market is entirely unlike a savings account, and the gains have nothing to do with compound interest!"

Yes, you can back-calculate a CAGR (Compound Annual Growth Rate) for an investment, but you can produce that number for any investment, even if compound interest had nothing to do with its growth. A $100k investment that grows linearly at $10k per year over 10 years (uncompounded, from $100k to $200k) has a CAGR of 7.2%, even though no compounding was taking place. So I think it's misleading to then turn that around and use the word "C" from CAGR when talking about predictive investment returns. It would be clearer to say "the money will grow an average of 7% each year" and keep compounding out of it.

My essay above was an attempt to show that stock market gains, despite misapplication of the term, do actually have a connection to compound interest. It's not as directly visible as it is in a savings account, but it's there, and can be used to give yourself some confidence that stocks have at least some solidity behind them.

I still think, however, that it adds unnecessary confusion when writers link compounding with the stock market.

arebelspy

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Re: In what sense do stock gains "compound"?
« Reply #40 on: April 02, 2014, 11:40:45 AM »
Great post skyrefuge.
We are two former teachers who accumulated a bunch of real estate, retired at 29, spent some time traveling the world full time and are now settled with two kids.
If you want to know more about us, or how we did that, or see lots of pictures, this Business Insider profile tells our story pretty well.
We (rarely) blog at AdventuringAlong.com. Check out our Now page to see what we're up to currently.

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Re: In what sense do stock gains "compound"?
« Reply #41 on: April 02, 2014, 07:05:13 PM »
Yes, thanks a lot, skyrefuge. That was a very lucid explanation.

FrenchyMustache

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Re: In what sense do stock gains "compound"?
« Reply #42 on: April 02, 2014, 07:19:23 PM »
Yeah, thanks for that.

I also watched over France, and yeah, the index is not CAC40, it would be CAC ALL TRADEABLE formerly known as SBF 500.
Just for the little off track, the Franche Stocks goes like this :

Cac AllTradeable Contains (CAC40 for the 40 top stocks, then CAC NEXT 20, then CAC MID 60, and finally CAC SMALL for the little ones.)

My main concern is the price. If i'm going to buy One Index at 3000 each, it'll be like buying one each 3 or 4 month, even more. Isnt that slowing down the compounding ?