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. :-)