Are all investments compound interest?

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Derivative
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Are all investments compound interest?

Post by Derivative » Sun Sep 24, 2017 2:04 am

Are all investments compound interest? Right now I have about $24k in "purchases and withdrawals" and $5k in "investment returns" in my Vanguard IRA account. It states that my "rate of return*" is 9.3% and my ending balance to be about $29k. My question is: does the "rate of return" (9%) compound on the $29k? In other words, if it is 9% returns every year, is this compound interest?

I am having hard time understanding this question because I know that we buy shares and that the price of individual shares can go up or down, so how does this translate to compounding? If we only buy and hold shares, I don't get how we get the compound effect on our investments??

JBTX
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Re: Are all investments compound interest?

Post by JBTX » Sun Sep 24, 2017 2:14 am

Derivative wrote:
Sun Sep 24, 2017 2:04 am
Are all investments compound interest? Right now I have about $24k in "purchases and withdrawals" and $5k in "investment returns" in my Vanguard IRA account. It states that my "rate of return*" is 9.3% and my ending balance to be about $29k. My question is: does the "rate of return" (9%) compound on the $29k? In other words, if it is 9% returns every year, is this compound interest?

I am having hard time understanding this question because I know that we buy shares and that the price of individual shares can go up or down, so how does this translate to compounding? If we only buy and hold shares, I don't get how we get the compound effect on our investments??
I can't speak exactly how the vanguard rate of return computes.

However, conceptually, to compute a rate of return (or internal rate of return) you take a series of cash flows out (your initial outflow, plus subsequent purchases), and cash flows in (your interest and dividends - but only if paid out to you and NOT reinvested, and your terminal / market value as of today) and based upon the time periods they are incurred, you can come up with a computed internal rate of return. Ultimately you would only look at the cash amounts. The number of shares is irrelevant in determining internal rate of return.

livesoft
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Re: Are all investments compound interest?

Post by livesoft » Sun Sep 24, 2017 2:18 am

Here is a wiki article: https://www.bogleheads.org/wiki/Percent ... n_and_loss

No, all investments do not compound interest.
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JBTX
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Re: Are all investments compound interest?

Post by JBTX » Sun Sep 24, 2017 2:27 am

livesoft wrote:
Sun Sep 24, 2017 2:18 am
Here is a wiki article: https://www.bogleheads.org/wiki/Percent ... n_and_loss

No, all investments do not compound interest.
My guess would be if the statement presents a rate of return that approximates an internal rate of return, that the rate is effectively a "compounded" interest rate. Would you agree?

An equity investment of $100, that grows to $161.05 in five years, would be a rate of return of 10%, compounded annually.

Note: I am not implying that the equity investment has any sort of compounding built in it, like a savings account, just that the rate of return is implicitly a compounded rate.

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Re: Are all investments compound interest?

Post by livesoft » Sun Sep 24, 2017 2:31 am

The reported rate is an annualized rate if it says it is an annualized rate.
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TJSI
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Re: Are all investments compound interest?

Post by TJSI » Sun Sep 24, 2017 6:35 am

Not all investments compound. However you can always compute an equivalent compound rate. This causes a lot of confusion. It is useful to compute a compound rate to compare investments. But the fact that you can compute it does not make the underlying investment compound.

TJSI

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Re: Are all investments compound interest?

Post by The Wizard » Sun Sep 24, 2017 6:49 am

OP should not be talking compound interest with regard to stocks and stock funds.
Stock funds issue dividends every three months or so.
And the value of each share in a stock fund fluctuates up and down over time.

If that $24k in your IRA declined in value to $22k, what would the annualized compound interest be?
That's a silly question that I asked because the terminology is not relevant to a stock mutual fund.

Now it is true that if you reinvest dividends in a stock mutual fund, your number of shares grows larger at maybe 1.5% per year. But the proper terminology here is Growth or Total Return, not compounding...
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Re: Are all investments compound interest?

Post by #Cruncher » Sun Sep 24, 2017 6:56 am

Derivative wrote:
Sun Sep 24, 2017 2:04 am
My question is: does the "rate of return" (9%) compound on the $29k?
The reported rate of return refers to the past. It does not automatically apply to the future.
continuing, Derivative wrote:In other words, if it is 9% returns every year, is this compound interest?
The reported return refers to the overall period, not necessarily to every year. For example, assume you contribute $8,000 to your IRA at the beginning of each year for three years. Also, assume that the IRA value at the end of each year is $9,000, $17,848, and $29,128.

As shown in the table below, two of the years had a return of over 12%; but one had a return of only 5%. Based on this and its exact method of computation, Vanguard might report that you had a 10% overall annual return.

Code: Select all

               Yr End
Year  Invest    Value   Growth
----  ------   ------   ------
  1    8,000    9,000   1.1250 =  9000 / (    0 + 8000)
  2    8,000   17,848   1.0499 = 17848 / ( 9000 + 8000)
  3    8,000   29,128   1.1269 = 29128 / (17848 + 8000)
                        ------
Product                 1.3310 = 1.1250 * 1.0499 * 1.1269
Compound Annual Return  10.00% = 1.3310 ^ (1 / 3) - 1

JBTX wrote:
Sun Sep 24, 2017 2:27 am
Note: I am not implying that the equity investment has any sort of compounding built in it, like a savings account, just that the rate of return is implicitly a compounded rate.
This can be illustrated by assuming the three annual $8,000 investments above were made into a savings account paying 10% interest. If interest is compounded annually, at the end of three years, you'd have the same $29,128 as in the IRA example above.

Code: Select all

                 10%     Yr End
Year  Invest  Interest    Value
----  ------  --------   ------
  1    8,000      800     8,800 
  2    8,000    1,680    18,480 
  3    8,000    2,648    29,128
      ------    -----
Total 24,000    5,128

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Re: Are all investments compound interest?

Post by grabiner » Sun Sep 24, 2017 8:04 am

TJSI wrote:
Sun Sep 24, 2017 6:35 am
Not all investments compound. However you can always compute an equivalent compound rate. This causes a lot of confusion. It is useful to compute a compound rate to compare investments. But the fact that you can compute it does not make the underlying investment compound.
Here's an example.

Suppose you invest $10,000 in a CD with a 4% rate, paying interest every six months. You will earn $200 in the first six months, and $204 in the next six months since you earn interest on the $200. This is compound interest, The CD will report a 4.04% annual percentage yield, because 4% compounded every six months is an annual return of 4.04%.

Suppose you buy $10,000 in bonds with a 4% coupon, payable every six months. The bonds pay simple interest; you will receive $200 in six months, and that $200 stops earning interest from these bonds, so you will get another $200 in one year, not $204.

However, if you reinvest the $200 paid in the first six months, then your returns will compound. For example, if you hold a bond fund, and reinvest the distributions, then the $200 you received after six months will be used to buy more bonds, and if those bonds have the same coupon rate, you will get another $4 from those $200. Your return for the year will then be 4.04%.

The difference between these two situations is that the CD guarantees compounding of interest, while the bonds do not. If interest rates change, you are not guaranteed to get $4 in interest by reinvesting the $200 bond coupon.
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dbr
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Re: Are all investments compound interest?

Post by dbr » Sun Sep 24, 2017 9:12 am

What is compounding? Compounding means that the return in any period is applied to the asset value at the beginning of that period. That asset value in turn is the result of having applied return to the asset value at the beginning of the previous period. Going forward, the asset value at the end of any future period is gotten by applying return to the asset value at the beginning of that period.

This means that gains in any future period are gotten by applying return to the initial principle and to the accumulated returns from all previous periods.

Please contemplate this until it is clear, as if it is not clear, there will be perpetual confusion as to how investments compound.

In the past I have written out algebraic expressions that to me make this description crystal clear, but that is a lot of work and would probably best be left as an exercise for the readers this time. Note one point that causes a lot of confusion when applying the notion of compounding to investments in general is that the return in period can be negative. But, trust me, it still works. Further, mention of average return generates all sorts of confusion. Such confusion is simple to eliminate if everything is done using mathematical expressions, again an exercise for the readers.

PS Another point of confusion is that compounding of investment return is NOT "compound interest," but the problem is not with the notion of compounding but with the fact that dividends and capital gains are not interest.

Derivative
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Re: Are all investments compound interest?

Post by Derivative » Sun Sep 24, 2017 10:09 pm

Thanks for all of your replies and answers.

My question is this:

If investments do not compound, why do all financial books have graphs on the "power of compounding"??

I still am not clear if the money I have in my Roth IRA at Vanguard with 740 shares of VFFVX (Vanguard Target Retirement 2055 Fund Investor Shares) are compounding or not? Basically, will the $30k I have in my Roth IRA compound if I just leave it there? I am very frustrated with this question and the answer.

avalpert
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Re: Are all investments compound interest?

Post by avalpert » Sun Sep 24, 2017 10:22 pm

Derivative wrote:
Sun Sep 24, 2017 10:09 pm
Thanks for all of your replies and answers.

My question is this:

If investments do not compound, why do all financial books have graphs on the "power of compounding"??

I still am not clear if the money I have in my Roth IRA at Vanguard with 740 shares of VFFVX (Vanguard Target Retirement 2055 Fund Investor Shares) are compounding or not? Basically, will the $30k I have in my Roth IRA compound if I just leave it there? I am very frustrated with this question and the answer.
What do you think it means for your $30k in that IRA to 'compound'?

In the sense that one period's (of whatever length you want to measure) growth rate (which can be positive or negative) compounds on the previous periods, then yes it compounds. But that isn't a exponential growth function like with interest as each period's growth rate is also independent from the previous. Those graphs are designed to show you that with investments expected to grow over time, the more time you have for them to grow the larger they are expected to get.

delamer
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Re: Are all investments compound interest?

Post by delamer » Sun Sep 24, 2017 10:32 pm

The simple answer is that stocks/stock funds are an investment type that do not pay interest, so therefore they do not produce compound interest. So all investments are not compound interest.

onthecusp
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Re: Are all investments compound interest?

Post by onthecusp » Sun Sep 24, 2017 11:04 pm

Derivative wrote:
Sun Sep 24, 2017 10:09 pm
Thanks for all of your replies and answers.

My question is this:

If investments do not compound, why do all financial books have graphs on the "power of compounding"??

I still am not clear if the money I have in my Roth IRA at Vanguard with 740 shares of VFFVX (Vanguard Target Retirement 2055 Fund Investor Shares) are compounding or not? Basically, will the $30k I have in my Roth IRA compound if I just leave it there? I am very frustrated with this question and the answer.
I'll speak to "returns", not "interest."

Some investments do compound, some don't, and it is complicated; but good investment books rightly point you at investments which do. Your target retirement shares are compounding your returns if you don't sell your gains. Returns next year are a return on what you have in the fund at the end of this year. The returns are not set aside, but are reinvested within the fund so the value of the shares go up every year (except if they go down due to a bad year in the market in which case it is compounding in a negative direction).

I don't know about your particular fund, but you may have to direct Vanguard to reinvest dividends within the fund to maximize compounding within the fund. I have a few funds which I have directed Fidelity to accumulate the dividends separately within my account and I then choose which fund to reinvest them in. I feel that I am compounding within my account as a whole by doing this but it is an unnecessary complication and reduces the compounding within that particular fund. If you see cash showing up in your account but outside the fund you should look into this.

Most investments compound if you leave them there long enough and reinvest any return.

Let's take some examples.
For an initial investment of $10,000 where at the end of year 1 you have $11,000 in the investment. You gained 10%. This could have been:
a. A stock that went up 10% and did not pay any dividends. If it goes up another 10% you have $12,100 ($11,000 + ($11,000 x 10%). That is compound gains.
b. A stock that went up 10% and did not pay any dividends. If it goes down 5% you have $10,450 ($11,000 + ($11,000 x -5%). That is compounding resulting from a series of gain and loss.
c. A stock that is paying 10% dividends but the price did not change. If you buy more stock with the dividends the investment is compounding within the stock. If you buy different stock with the dividends the investment is compounding within the account.

Investments that don't necessairly compound.
a. You buy a simple immediate annuity. It pays the same every year for the rest of your life.
b. You buy a 1 year CD that will pay 2% at the end of a year on your $10,000. At the end of the year you spend your $10,200 on a great vacation. Nothing compounded there because it was expressed as an annual interest rate. Now if you reinvested the $10,200 in a new CD you have created compounding even while the new CD is exactly the same as the old, you just invested an extra 200 and will get interest next year on the previous year's gains.

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Re: Are all investments compound interest?

Post by Wakefield1 » Sun Sep 24, 2017 11:32 pm

I had a passbook savings account at a bank while I was young that added interest quarterly,that interest then earned interest over the next quarter if you didn't make a withdrawal.I guess that was quarterly compounding. Later some banks (or S&Ls) began advertising that they compounded monthly. Then some started advertising daily compounding. Finally one of them advertised "continuous compounding". Integral calculus? Univacy?
I guess expressing interest as "APY" is intended to put interest claims on a common standard.

Do reinvested stock distributions compound but are not interest?

venkman
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Re: Are all investments compound interest?

Post by venkman » Sun Sep 24, 2017 11:33 pm

Derivative wrote:
Sun Sep 24, 2017 10:09 pm
Thanks for all of your replies and answers.

My question is this:

If investments do not compound, why do all financial books have graphs on the "power of compounding"??

I still am not clear if the money I have in my Roth IRA at Vanguard with 740 shares of VFFVX (Vanguard Target Retirement 2055 Fund Investor Shares) are compounding or not? Basically, will the $30k I have in my Roth IRA compound if I just leave it there? I am very frustrated with this question and the answer.
It will compound, just not necessarily in the same way that interest in a savings account compounds.

Every so often, the fund pays out dividends, which you reinvest to buy more shares of the fund. If you started the year with those 740 shares of VFFVX, and the fund pays a 2% dividend, you should end the year with ~755 shares. Next year, if the fund has a 5% return, you will get that return on the 755 shares you own. (And you'll get more dividends to reinvest, and end the year with even MORE shares.) That's the traditional way to think about compounding.

The other way to think about it is that, through the fund, you own a small piece of many different companies. Those companies earn profits, which they can distribute as dividends OR invest back into the business to grow it. When they choose to grow the business, you may not get paid a dividend; but you will end up owning a stake in a company that is larger and more profitable (which will be reflected in a higher stock price).

The important thing is that the VFFVX in your IRA is compounding, in the sense of "compounding" that all the financial books talk about. It's just that it's compounding at an extremely variable rate.

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Re: Are all investments compound interest?

Post by The Wizard » Mon Sep 25, 2017 3:45 am

As I said earlier, "compounding" is the Wrong Term to use for mutual funds containing stocks. And "compound interest" is Even Worse.

Homework assignment for the OP: go to the Morningstar website and click on the magnifying glass and enter VFFVX.
Then click on the Chart tab and examine the blue line on the Chart.
This blue line is the value of $10,000 invested in VFFVX back at the beginning of this fund in 2010.
Now describe to us in your own words what has happened to that original $10,000 over the past seven years...
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Re: Are all investments compound interest?

Post by dbr » Mon Sep 25, 2017 7:34 am

The Wizard wrote:
Mon Sep 25, 2017 3:45 am
As I said earlier, "compounding" is the Wrong Term to use for mutual funds containing stocks. And "compound interest" is Even Worse.
Then what are we to make of commonly used terms such as Compound Annual Growth Rate? I agree that using the word interest in place of return is a misunderstanding.

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Re: Are all investments compound interest?

Post by avalpert » Mon Sep 25, 2017 7:39 am

dbr wrote:
Mon Sep 25, 2017 7:34 am
The Wizard wrote:
Mon Sep 25, 2017 3:45 am
As I said earlier, "compounding" is the Wrong Term to use for mutual funds containing stocks. And "compound interest" is Even Worse.
Then what are we to make of commonly used terms such as Compound Annual Growth Rate? I agree that using the word interest in place of return is a misunderstanding.
It's a useful tool to make backward looking comparisons across assets - possibly in a way that confuses people not fully knowledgeable (and probably many who are) about the math and theory behind it all.

For example, does everyone who uses the past average return (or CAGR) as an assumed CAGR going forward realize how tenuous an assumption that is - I doubt it.

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Re: Are all investments compound interest?

Post by dbr » Mon Sep 25, 2017 7:46 am

avalpert wrote:
Mon Sep 25, 2017 7:39 am
dbr wrote:
Mon Sep 25, 2017 7:34 am
The Wizard wrote:
Mon Sep 25, 2017 3:45 am
As I said earlier, "compounding" is the Wrong Term to use for mutual funds containing stocks. And "compound interest" is Even Worse.
Then what are we to make of commonly used terms such as Compound Annual Growth Rate? I agree that using the word interest in place of return is a misunderstanding.
It's a useful tool to make backward looking comparisons across assets - possibly in a way that confuses people not fully knowledgeable (and probably many who are) about the math and theory behind it all.

For example, does everyone who uses the past average return (or CAGR) as an assumed CAGR going forward realize how tenuous an assumption that is - I doubt it.
I meant my question in the context of whether or not investments with variable annual returns can be said to compound. If you use or refer to such a term as CAGR you are using a concept in which such investments do compound in the sense the OP wants to understand.

As far as looking forward, investors reasonably assume compound growth of returns unless they think they can withdraw the return or part of it as free money and still see growth of assets. Isn't compounding of returns a major part of the incentive to defer consumption and invest instead?

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Re: Are all investments compound interest?

Post by livesoft » Mon Sep 25, 2017 7:55 am

Derivative wrote:
Sun Sep 24, 2017 10:09 pm
Thanks for all of your replies and answers.

My question is this:

If investments do not compound, why do all financial books have graphs on the "power of compounding"??

I still am not clear if the money I have in my Roth IRA at Vanguard with 740 shares of VFFVX (Vanguard Target Retirement 2055 Fund Investor Shares) are compounding or not? Basically, will the $30k I have in my Roth IRA compound if I just leave it there? I am very frustrated with this question and the answer.
I don't know why books do what they do. I will guess that in Ye Olde Days that people were familiar with savings accounts and used them for many goals. Even so, laws had to be changed to discuss APE and APY and interest rates because most people apparently did not understand them.

As for your investment in VFFVX, you get will growth in the shares you own hopefully (but you might get losses, too) and you will get growth in that growth. And you will get growth in that growth in that growth. If you want to call that compounding, then you can. But if you want to call that "interest", then you cannot.

And suppose you have an investment that pays no interest and no dividends. They exist and one example is Berkshire Hathaway stock shares. If the share price goes up, then the owners can sell at the higher share price. That's called growth. Does it "compound"?

One can take ANY change of share price (or even NAV of a fund like VFFVX) and calculate an annual change in price or if you will "growth". Or one can calculate a simple change in price from a starting point to an ending point. The time range does not change the actual amount of growth, but one can express the same growth in many ways. Here are some examples:

My fund tripled in value from beginning of 2009 to beginning of 2012.
My fund went up 200% in value from 2009 to 2012.
My fund grew at 44.2% a year from 2009 to 2012.
My fund went up 100% in 2009, then went up 22.4% for each of the next 2 years.
My fund doubled in value in 2009, then dropped 30% in value in 2010, then went up 114.3% in 2011.

In all 5 of those above examples, one would have the same ending value of their investment (if I did the math right; you'd better check it).
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Re: Are all investments compound interest?

Post by dbr » Mon Sep 25, 2017 8:03 am

livesoft wrote:
Mon Sep 25, 2017 7:55 am

One can take ANY change of share price (or even NAV of a fund like VFFVX) and calculate an annual change in price or if you will "growth". Or one can calculate a simple change in price from a starting point to an ending point. The time range does not change the actual amount of growth, but one can express the same growth in many ways. Here are some examples:

My fund tripled in value from beginning of 2009 to beginning of 2012.
My fund went up 200% in value from 2009 to 2012.
My fund grew at 44.2% a year from 2009 to 2012.
My fund went up 100% in 2009, then went up 22.4% for each of the next 2 years.
My fund doubled in value in 2009, then dropped 30% in value in 2010, then went up 146.4% in 2011.

In all 5 of those above examples, one would have the same ending value of their investment (if I did the math right; you'd better check it).
All of the above contains helpful things to think about.

The heart of this discussion comes to deciding to use conventional terminology to discuss investments and how they behave. One part of that terminology is the importance of the idea of return to talk about investing. More specifically in the examples above we go to example 5 and talk about what happens year by year and we relate the gain to what we started with at the beginning of each year and call that return. The process of up this year and down that year is compounding (or if someone does not want to use that word in that context it will be helpful to come up with some other word to talk about it). There is also a special word for example 2. Nobody has to fall back on the conventional terminology, but it is really useful to do so.

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Re: Are all investments compound interest?

Post by avalpert » Mon Sep 25, 2017 8:07 am

dbr wrote:
Mon Sep 25, 2017 7:46 am
avalpert wrote:
Mon Sep 25, 2017 7:39 am
dbr wrote:
Mon Sep 25, 2017 7:34 am
The Wizard wrote:
Mon Sep 25, 2017 3:45 am
As I said earlier, "compounding" is the Wrong Term to use for mutual funds containing stocks. And "compound interest" is Even Worse.
Then what are we to make of commonly used terms such as Compound Annual Growth Rate? I agree that using the word interest in place of return is a misunderstanding.
It's a useful tool to make backward looking comparisons across assets - possibly in a way that confuses people not fully knowledgeable (and probably many who are) about the math and theory behind it all.

For example, does everyone who uses the past average return (or CAGR) as an assumed CAGR going forward realize how tenuous an assumption that is - I doubt it.
I meant my question in the context of whether or not investments with variable annual returns can be said to compound. If you use or refer to such a term as CAGR you are using a concept in which such investments do compound in the sense the OP wants to understand.

As far as looking forward, investors reasonably assume compound growth of returns unless they think they can withdraw the return or part of it as free money and still see growth of assets. Isn't compounding of returns a major part of the incentive to defer consumption and invest instead?
The way I would frame it for equity investments (as opposed to fixed income investments with a contractually obligated periodic payment) is that the incentive is the expectation that it will grow more with more time - breaking it down into annual periods and saying one builds on the other is a wholly artificial construct which may have some usefulness for decision making and communication (and possibly with some detriment as well) but isn't an inherent aspect of the investment itself.

With assumptions, it would actually be better to assume total growth for your measurement period and a single error bar than a periodic rate (annual or otherwise) with compounding error bars, but that isn't practical for many types of scenario models and may not be as effective at motivating saving (that I don't know but would entertain the argument).

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Re: Are all investments compound interest?

Post by dbr » Mon Sep 25, 2017 8:08 am

Another thought here. It is incorrect to say that what investments DO is compound. A more useful idea is to say that compound growth is a very useful concept that we use to understand how investments behave. A psychology that might be useful here is to invest by understanding investments rather than invest by letting investments do things to us.

avalpert
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Re: Are all investments compound interest?

Post by avalpert » Mon Sep 25, 2017 8:10 am

dbr wrote:
Mon Sep 25, 2017 8:03 am
livesoft wrote:
Mon Sep 25, 2017 7:55 am

One can take ANY change of share price (or even NAV of a fund like VFFVX) and calculate an annual change in price or if you will "growth". Or one can calculate a simple change in price from a starting point to an ending point. The time range does not change the actual amount of growth, but one can express the same growth in many ways. Here are some examples:

My fund tripled in value from beginning of 2009 to beginning of 2012.
My fund went up 200% in value from 2009 to 2012.
My fund grew at 44.2% a year from 2009 to 2012.
My fund went up 100% in 2009, then went up 22.4% for each of the next 2 years.
My fund doubled in value in 2009, then dropped 30% in value in 2010, then went up 146.4% in 2011.

In all 5 of those above examples, one would have the same ending value of their investment (if I did the math right; you'd better check it).
All of the above contains helpful things to think about.

The heart of this discussion comes to deciding to use conventional terminology to discuss investments and how they behave. One part of that terminology is the importance of the idea of return to talk about investing. More specifically in the examples above we go to example 5 and talk about what happens year by year and we relate the gain to what we started with at the beginning of each year and call that return. The process of up this year and down that year is compounding (or if someone does not want to use that word in that context it will be helpful to come up with some other word to talk about it). There is also a special word for example 2. Nobody has to fall back on the conventional terminology, but it is really useful to do so.
I wonder if calling it 'sequencing' (which is what it really is) might be more helpful overall in that it will help illuminate the impact of cash flow timing on the ultimate outcomes.

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Re: Are all investments compound interest?

Post by The Wizard » Mon Sep 25, 2017 8:11 am

dbr wrote:
Mon Sep 25, 2017 7:34 am
The Wizard wrote:
Mon Sep 25, 2017 3:45 am
As I said earlier, "compounding" is the Wrong Term to use for mutual funds containing stocks. And "compound interest" is Even Worse.
Then what are we to make of commonly used terms such as Compound Annual Growth Rate? I agree that using the word interest in place of return is a misunderstanding.
Excellent point.
Yes, we can use CAGR to analyze past performance of any type of lump sum investment from a start time to some later time.
But CAGR tells us nothing about what wild swings in value may have occurred during that time period.
And more importantly, it tells us nothing about what to reasonably expect over the next 12 months.

So with relative newbies to investing, I prefer to deemphasize past performance of stock funds and instead, look more at their volatility, to reduce the chance of behavioral mistakes...
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Re: Are all investments compound interest?

Post by dbr » Mon Sep 25, 2017 8:17 am

avalpert wrote:
Mon Sep 25, 2017 8:07 am

The way I would frame it for equity investments (as opposed to fixed income investments with a contractually obligated periodic payment) is that the incentive is the expectation that it will grow more with more time - breaking it down into annual periods and saying one builds on the other is a wholly artificial construct which may have some usefulness for decision making and communication (and possibly with some detriment as well) but isn't an inherent aspect of the investment itself.

Yes, an excellent point. I was typing my next post as you posted this.

With assumptions, it would actually be better to assume total growth for your measurement period and a single error bar than a periodic rate (annual or otherwise) with compounding error bars, but that isn't practical for many types of scenario models and may not be as effective at motivating saving (that I don't know but would entertain the argument).

One of the things implicit in compound growth of annual returns is that variability of annual returns predicts the variability of total growth at the end of a longer period. That is why the idea that short term volatility is irrelevant to long term investing is such a wrong and pernicious idea. The better idea is to characterize all the features of investing instead of stopping short with only part of the picture. I do believe there is a whole picture here that is very useful to understand. Use of the compounding concept is an extremely helpful if not essential part of that picture. Anyone that has a different picture that is as useful can certainly implement their own. It is also possible to gain insight from alternatives. One important feature of this is understanding what other people are taking about when one reads about investments or contemplates data about investments. Im like to recommend that people look at retirement planning models to help understand their own plans. All of those models implement a compound growth algorithm to calculate their results. I would be at a loss to understand how else this could be done, especially if one intends to model contributions and withdrawals over time.

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Re: Are all investments compound interest?

Post by dbr » Mon Sep 25, 2017 8:23 am

avalpert wrote:
Mon Sep 25, 2017 8:10 am
I wonder if calling it 'sequencing' (which is what it really is) might be more helpful overall in that it will help illuminate the impact of cash flow timing on the ultimate outcomes.
[/quote]

Why invent a new word when the old word is already in use for the concept? The missing element here is to recognize the validity of generalizing a concept from a constant fixed return (aka interest) to variable return. The essence and significance of the original concept at fixed interest is so useful that it makes no sense to change the name.

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Re: Are all investments compound interest?

Post by JW-Retired » Mon Sep 25, 2017 8:55 am

Derivative wrote:
Sun Sep 24, 2017 10:09 pm
If investments do not compound, why do all financial books have graphs on the "power of compounding"??

I still am not clear if the money I have in my Roth IRA at Vanguard with 740 shares of VFFVX (Vanguard Target Retirement 2055 Fund Investor Shares) are compounding or not? Basically, will the $30k I have in my Roth IRA compound if I just leave it there? I am very frustrated with this question and the answer.
Firstly, you generally do need to make a choice to reinvest any dividends and realized capital gains that the fund throws off, back into the fund. This is always a choice you can make. If you take these earnings out every year the account obviously won't grow as fast. Since it's a Roth IRA I think most everyone would/should be reinvesting these earnings.

The account will hopefully grow year over year, but it will do so in fits and starts depending on the stock market. Some years it will probably shrink. It doesn't do anything I would think looks like simple "compounding".
JW
ps: here is a growth of $10k chart of VFFVX assuming you leave all the earnings in the account. Close enough to your idea of compounding?
http://www.morningstar.com/funds/XNAS/VFFVX/quote.html
Last edited by JW-Retired on Mon Sep 25, 2017 9:11 am, edited 3 times in total.
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Re: Are all investments compound interest?

Post by rbaldini » Mon Sep 25, 2017 8:56 am

Derivative wrote:
Sun Sep 24, 2017 2:04 am
Are all investments compound interest?
Most boglehead-type investments are thought of as compounding: stocks, bonds, savings accounts, real estate property value. What wouldn't be? I think the rent income from investing in real estate would not count as compounding, because you get some fixed amount of money every month according to a contract. Of course, that number will probably go up over time, so even then you might think of it as compounding, sort of.

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Re: Are all investments compound interest?

Post by bertilak » Mon Sep 25, 2017 9:04 am

Derivative wrote:
Sun Sep 24, 2017 10:09 pm
Thanks for all of your replies and answers.

My question is this:

If investments do not compound, why do all financial books have graphs on the "power of compounding"??

I still am not clear if the money I have in my Roth IRA at Vanguard with 740 shares of VFFVX (Vanguard Target Retirement 2055 Fund Investor Shares) are compounding or not? Basically, will the $30k I have in my Roth IRA compound if I just leave it there? I am very frustrated with this question and the answer.
But many equity investments DO compound their earnings. Whenever something produces earnings that remain invested, the earnings are said to be compounding by definition of the term. The same is true for losses.

Earnings can be realized by the investor in several ways:
  1. A company can keep the earnings to help the company grow and therefore increase future earnings. All else being equal, the stock price should go up.
  2. A company can buy back shares on the open market making each remaining share represent a larger portion of the company and therefore a larger portion of the company's future earnings. Again, all else being equal, the stock price should go up.
  3. A company can return the earnings to the investor as dividends.
A company can do a mix of all of that.

In cases 1 and 2, the growth is inherently compounded (remains invested). In case 3 the investor can manually reinvest the returns and thereby reap the "power of compounding." When reporting on growth it is generally assumed that the investor does this.

Bonds are different, but the investor can manually reinvest here as well, probably by buying different bonds or more of a bond mutual fund which amounts to about the same thing.

Note the distinction between "earnings," "growth" and "returns." Depending on context or on how precise someone wants to be the terms are somewhat interchangeable but your question requires a precise answer.

Note also that I am no expert so I may have misused the terminology (only slightly, I hope) and may have missed or glossed over something important.
Last edited by bertilak on Mon Sep 25, 2017 9:10 am, edited 1 time in total.
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Re: Are all investments compound interest?

Post by avalpert » Mon Sep 25, 2017 9:05 am

dbr wrote:
Mon Sep 25, 2017 8:23 am
avalpert wrote:
Mon Sep 25, 2017 8:10 am
I wonder if calling it 'sequencing' (which is what it really is) might be more helpful overall in that it will help illuminate the impact of cash flow timing on the ultimate outcomes.
Why invent a new word when the old word is already in use for the concept? [/quote]
Because the current word used confuses some and may reinforce a common equivocation between interest and equity returns (and particularly dividends) that leads to poor decisions.

For me, I don't care what word is used - I understand how the concept being described actually operates so whatever term people want to use to describe it is fine by me as long as they don't try to use the happenstance of the term to confuse what is actually going on.

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Re: Are all investments compound interest?

Post by dbr » Mon Sep 25, 2017 9:07 am

JW-Retired wrote:
Mon Sep 25, 2017 8:55 am

Firstly, you generally do need to make a choice to reinvest any dividends and realized capital gains that the fund throws off, back into the fund. This is always a choice you can make. If you take these earnings out every year the account obviously won't grow as fast. Since it's a Roth IRA I think most everyone would/should be reinvesting these earnings.

Just so.

A good way to think about that in a way that is consistent with the definitions of return and compounding is that not reinvesting dividends is the same as making a withdrawal from the portfolio. If you start from the point of view that dividends are a pay check that someone is giving you, then you get crosswise with thinking in a logically consistent manner about the investment.

How you think about the investment and how you manage it are two different things. The first is supposed to help you do the second wisely.

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Re: Are all investments compound interest?

Post by dbr » Mon Sep 25, 2017 9:10 am

avalpert wrote:
Mon Sep 25, 2017 9:05 am
dbr wrote:
Mon Sep 25, 2017 8:23 am
avalpert wrote:
Mon Sep 25, 2017 8:10 am
I wonder if calling it 'sequencing' (which is what it really is) might be more helpful overall in that it will help illuminate the impact of cash flow timing on the ultimate outcomes.
Why invent a new word when the old word is already in use for the concept?
Because the current word used confuses some and may reinforce a common equivocation between interest and equity returns (and particularly dividends) that leads to poor decisions.
[/quote]

That is a valid point. My opinion is that the best fix for that is to explain the concept of compounding as a general idea. That is going to be pretty much necessary in either case. Your suggestion might work very well if the world had not already gone the other way. My first post on this thread was to reply to the OP with exactly the explanation of compounding in general. The explanation I wrote would be the same if one wanted to substitute "sequencing" for "compounding" but still would have been just as necessary.

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Re: Are all investments compound interest?

Post by livesoft » Mon Sep 25, 2017 9:15 am

I would just say that not all investments compound interest. Most investments compound growth.
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Re: Are all investments compound interest?

Post by goingup » Mon Sep 25, 2017 9:16 am

Derivative wrote:
Sun Sep 24, 2017 10:09 pm
Basically, will the $30k I have in my Roth IRA compound if I just leave it there?
Yes, it will compound and you'll acquire more shares if the dividends are reinvesting. This doesn't mean the value will increase, necessarily. That depends entirely on the stock market.

The generic term compound means:
a thing that is composed of two or more separate elements; a mixture.

You have your 740 shares right now worth 30K. At the end of December you'll get a dividend which will buy more shares. That's the compound--the old shares plus the new shares. You'll have compounded growth of shares, but no one can tell you if this will be worth more or less than 30K. :D

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Re: Are all investments compound interest?

Post by dbr » Mon Sep 25, 2017 9:26 am

livesoft wrote:
Mon Sep 25, 2017 9:15 am
I would just say that not all investments compound interest. Most investments compound growth.
That is true and actually very important, but it does not explain the concept of compounding. We are not sure if the OP does or does not really understand that idea. A generalization to variable rate of growth is required and that may or may not be simple.

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Re: Are all investments compound interest?

Post by ThrustVectoring » Mon Sep 25, 2017 12:34 pm

Compound interest is one example out of a general trend of exponential growth. People generally stay invested today because they expect their investment to be worth slightly more tomorrow. And that "slightly more" is a small percentage of the current value today. So if you expect a 4% annual growth rate, you expect your investment today to be worth 1.04 times as much next year, 1.04^2 as much the year after, 1.04^3 the year after that, and so forth. And in ten years you expect not 40% more, but 1.04^10 = 48% more.

Most investments expect exponential growth of some sort. The exceptions are those that have difficulty reinvesting gains and puts profits into your pockets. Real estate is a good example - if you get a profit of $1000 from rent checks, it's difficult to turn that into more rental properties to profit off of.

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Re: Are all investments compound interest?

Post by avalpert » Mon Sep 25, 2017 12:37 pm

ThrustVectoring wrote:
Mon Sep 25, 2017 12:34 pm
Most investments expect exponential growth of some sort. The exceptions are those that have difficulty reinvesting gains and puts profits into your pockets. Real estate is a good example - if you get a profit of $1000 from rent checks, it's difficult to turn that into more rental properties to profit off of.
Why do you think it is more difficult in real estate than say a business that get a profit of $1000 from selling widgets today?

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Re: Are all investments compound interest?

Post by The Wizard » Mon Sep 25, 2017 1:29 pm

goingup wrote:
Mon Sep 25, 2017 9:16 am
Derivative wrote:
Sun Sep 24, 2017 10:09 pm
Basically, will the $30k I have in my Roth IRA compound if I just leave it there?
Yes, it will compound and you'll acquire more shares if the dividends are reinvesting. This doesn't mean the value will increase, necessarily. That depends entirely on the stock market.

The generic term compound means:
a thing that is composed of two or more separate elements; a mixture.
For what little it matters, this is not the definition of "compound" that we are talking about.
The one that's relevant here:

to pay (interest) on the accrued interest as well as the principal:
My bank compounds interest quarterly.
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Re: Are all investments compound interest?

Post by goingup » Mon Sep 25, 2017 1:52 pm

The Wizard wrote:
Mon Sep 25, 2017 1:29 pm
goingup wrote:
Mon Sep 25, 2017 9:16 am
Derivative wrote:
Sun Sep 24, 2017 10:09 pm
Basically, will the $30k I have in my Roth IRA compound if I just leave it there?
Yes, it will compound and you'll acquire more shares if the dividends are reinvesting. This doesn't mean the value will increase, necessarily. That depends entirely on the stock market.

The generic term compound means:
a thing that is composed of two or more separate elements; a mixture.
For what little it matters, this is not the definition of "compound" that we are talking about.
The one that's relevant here:

to pay (interest) on the accrued interest as well as the principal:
My bank compounds interest quarterly.
I think it's relevant. The example of compounded interest in your bank account example is what is confusing the OP. In his mutual fund investment, shares are creating more shares, and more shares, and more shares. Compounded growth of shares.

In your bank account the compounded interest is created growth of $$, provided you allow it to accrue. Different concept.

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Re: Are all investments compound interest?

Post by dbr » Mon Sep 25, 2017 1:55 pm

goingup wrote:
Mon Sep 25, 2017 1:52 pm

I think it's relevant. The example of compounded interest in your bank account example is what is confusing the OP. In his mutual fund investment, shares are creating more shares, and more shares, and more shares. Compounded growth of shares.
Believe me, once you start measuring the value of investments in shares the confusion created is immense. It is a much better idea to stick to the conventional language of value, gain, and return.

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Re: Are all investments compound interest?

Post by goingup » Mon Sep 25, 2017 2:05 pm

dbr wrote:
Mon Sep 25, 2017 1:55 pm
goingup wrote:
Mon Sep 25, 2017 1:52 pm

I think it's relevant. The example of compounded interest in your bank account example is what is confusing the OP. In his mutual fund investment, shares are creating more shares, and more shares, and more shares. Compounded growth of shares.
Believe me, once you start measuring the value of investments in shares the confusion created is immense. It is a much better idea to stick to the conventional language of value, gain, and return.
You're right! It's confusing. Hopefully the OP has gotten a satisfactory answer to his/her question, but I kind of doubt it. :confused

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Re: Are all investments compound interest?

Post by retiredjg » Mon Sep 25, 2017 2:40 pm

Derivative wrote:
Sun Sep 24, 2017 10:09 pm
Thanks for all of your replies and answers.

My question is this:

If investments do not compound, why do all financial books have graphs on the "power of compounding"??

I still am not clear if the money I have in my Roth IRA at Vanguard with 740 shares of VFFVX (Vanguard Target Retirement 2055 Fund Investor Shares) are compounding or not? Basically, will the $30k I have in my Roth IRA compound if I just leave it there? I am very frustrated with this question and the answer.
I didn't read all the answers, but my feeling is that the answers are too complicated. Let's back up to the beginning.

Invested money can make money in a lot of ways.

A savings account pays something called "interest". You leave your money there and they pay you a percentage of that every year. $100 invested at 10% interest will grow to $110 during the year. CD's pay interest. Money market pays interest. Etc. The amount of interest you will get is stated ahead of time and guaranteed. If they say they will pay you 10%, that is what you will get.

Stocks and bond funds do not pay interest at all. You make money on stocks because the share that you paid $10 for is now worth $14. That's called a "capital gain" or "earnings or growth" depending on the type of account the stocks are in. It is income or earnings, but it is NOT "interest". Bonds funds pay "dividends" - again, a kind of income that is NOT interest (but includes interest).

The income from stocks and bond funds is not guaranteed at all. Stocks can go down in value, not up. And even if the stocks go up, there is no guarantee how much or for how long. Bonds behave a little better, but the bond fund that pays 3% this year may pay 1% next year.

So you can see the answer to your question about "compound interest" is obviously "no" because you are not earning interest in the first place from your Target Retirement funds. You do have growth, but it is not growth from interest.


Turning to the other side of your question - compounding. Compounding simply means that the money you make turns around and makes money too. In the example of interest above, you start with $100 at 10% interest and a year later, you have $110. That $110 continues to make interest and a year later, you have more than just an extra $10 (you make $11 in year 2) because your $10 in earnings from year 1 is also now making money. :happy That is "compounding interest".

Since your stocks and bond funds don't pay any interest, can compounding occur? Yes, it certainly does. But it is not guaranteed and it may all disappear for awhile in the market crashes. In the example of the stock that you bought for $10 now being worth $14....yes that extra $4 in earnings also will start making you money. So yes, it does compound. However, if the stock then drops to being worth only $8....you have less money than you started with. So compounding hardly seems to matter during a crash. :(


The charts you see in books are a summary over a long time where your earnings or "growth" (as some call it do) compound. Your earnings do make earnings of their own over time. As long as the stock market continues to go up you get to keep it. Over time, so far, for us in the US, the market has gone up - with some very big dips and crashes along the way.

So yes, compounding is occurring inside your Target Fund.

ETA: some of you may recognize the finer details and see errors in this post. That's not really the point. This poster does not seem to understand exactly what "interest" is and that is what I was trying to address. I remember when I didn't know the difference either. Let's don't get bogged down in minutia that will not be helpful to our original poster.
Last edited by retiredjg on Mon Sep 25, 2017 3:15 pm, edited 1 time in total.

dbr
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Re: Are all investments compound interest?

Post by dbr » Mon Sep 25, 2017 2:45 pm

retiredjg wrote:
Mon Sep 25, 2017 2:40 pm
Derivative wrote:
Sun Sep 24, 2017 10:09 pm
Thanks for all of your replies and answers.

My question is this:

If investments do not compound, why do all financial books have graphs on the "power of compounding"??

I still am not clear if the money I have in my Roth IRA at Vanguard with 740 shares of VFFVX (Vanguard Target Retirement 2055 Fund Investor Shares) are compounding or not? Basically, will the $30k I have in my Roth IRA compound if I just leave it there? I am very frustrated with this question and the answer.
I didn't read all the answers, but my feeling is that the answers are too complicated. Let's back up to the beginning.

Invested money can make money in a lot of ways.

A savings account pays something called "interest". You leave your money there and they pay you a percentage of that every year. $100 invested at 10% interest will grow to $110 during the year. CD's pay interest. Money market pays interest. Etc. The amount of interest you will get is stated ahead of time and guaranteed. If they say they will pay you 10%, that is what you will get.

Stocks and bonds do not pay interest at all. You make money on stocks because the share that you paid $10 for is now worth $14. That's called a "capital gain" or "earnings or growth" depending on the type of account the stocks are in. It is income or earnings, but it is NOT "interest". Bonds pay dividends - again, a kind of income that is NOT interest.

The income from stocks and bonds is not guaranteed at all. Stocks can go down in value, not up. And even if the stocks go up, there is no guarantee how much or for how long. Bonds behave a little better, but the bond fund that pays 3% this year may pay 1% next year.

So you can see the answer to your question about "compound interest" is obviously "no" because you are not earning interest in the first place from your Target Retirement funds. You do have growth, but it is not growth from interest.


Turning to the other side of your question - compounding. Compounding simply means that the money you make turns around and makes money too. In the example of interest above, you start with $100 at 10% interest and a year later, you have $110. That $110 continues to make interest and a year later, you have more than just an extra $10 (you make $11 in year 2) because your $10 in earnings from year 1 is also now making money. :happy That is "compounding interest".

Since your stocks and bonds don't pay any interest, can compounding occur? Yes, it certainly does. But it is not guaranteed and it may all disappear for awhile in the market crashes. In the example of the stock that you bought for $10 now being worth $14....yes that extra $4 in earnings also will start making you money. So yes, it does compound. However, if the stock then drops to being worth only $8....you have less money than you started with. So compounding hardly seems to matter during a crash. :(


The charts you see in books are a summary over a long time where your earnings or "growth" (as some call it do) compound. Your earnings do make earnings of their own over time. As long as the stock market continues to go up you get to keep it. Over time, so far, for us in the US, the market has gone up - with some very big dips and crashes along the way.

So yes, compounding is occurring inside your Target Fund.
That is a pretty good write up. I would say that some concepts are only as simple as they are and not simpler.

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Re: Are all investments compound interest?

Post by avalpert » Mon Sep 25, 2017 2:51 pm

retiredjg wrote:
Mon Sep 25, 2017 2:40 pm
Bonds pay dividends - again, a kind of income that is NOT interest...

Bonds behave a little better, but the bond fund that pays 3% this year may pay 1% next year...
Of course bonds pay interest - they have a defined interest rate just like a CD. That there may be default risk doesn't change that. The bond funds interest may be lower next year because as it reinvests in new bonds (to maintain the same term exposure) interest rates may be lower, but that is no different than a CD or savings account.

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Re: Are all investments compound interest?

Post by ThrustVectoring » Mon Sep 25, 2017 2:55 pm

avalpert wrote:
Mon Sep 25, 2017 12:37 pm
ThrustVectoring wrote:
Mon Sep 25, 2017 12:34 pm
Most investments expect exponential growth of some sort. The exceptions are those that have difficulty reinvesting gains and puts profits into your pockets. Real estate is a good example - if you get a profit of $1000 from rent checks, it's difficult to turn that into more rental properties to profit off of.
Why do you think it is more difficult in real estate than say a business that get a profit of $1000 from selling widgets today?
Minimum investment sizes, really. You have enough savings and cash flow to support buying and renting out an integer number of properties. Getting income from 2 properties and using it to afford 2.2 instead doesn't help your real estate investment any.

There's some similar threshold effects in businesses as well - hiring employees, buying facilities, etc. There's also some lower threshold business development options, like buying advertisements.

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Re: Are all investments compound interest?

Post by straws46 » Mon Sep 25, 2017 3:06 pm

These are important concepts that can be hard to understand. If I had $100 and earned 100% in year one and then lost 50% in year two, I would have a 25% average return. (100 -50) /2 =25. But my CAGR would be zero since I would still have exactly the same $100 I started out with. When people, especially sales people, talk about returns is there anything that controls how they compute them?

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Re: Are all investments compound interest?

Post by retiredjg » Mon Sep 25, 2017 3:08 pm

avalpert wrote:
Mon Sep 25, 2017 2:51 pm
retiredjg wrote:
Mon Sep 25, 2017 2:40 pm
Bonds pay dividends - again, a kind of income that is NOT interest...

Bonds behave a little better, but the bond fund that pays 3% this year may pay 1% next year...
Of course bonds pay interest - they have a defined interest rate just like a CD. That there may be default risk doesn't change that. The bond funds interest may be lower next year because as it reinvests in new bonds (to maintain the same term exposure) interest rates may be lower, but that is no different than a CD or savings account.
Please cut me some slack here. I believe you are technically correct for individual bonds, but I was trying to be very simplistic to get the point across. To be honest, I could not tell you the difference between bond dividends and bond interest - I never hear it called interest, at least not with bond funds.

Ok, so I looked it up. Wikipedia says A bond fund or debt fund is a fund that invests in bonds, or other debt securities. Bond funds can be contrasted with stock funds and money funds. Bond funds typically pay periodic dividends that include interest payments on the fund's underlying securities plus periodic realized capital appreciation.

I'll go back and edit my post to only discuss bond funds - like what is in the poster's Target Fund.

avalpert
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Re: Are all investments compound interest?

Post by avalpert » Mon Sep 25, 2017 7:22 pm

retiredjg wrote:
Mon Sep 25, 2017 3:08 pm
avalpert wrote:
Mon Sep 25, 2017 2:51 pm
retiredjg wrote:
Mon Sep 25, 2017 2:40 pm
Bonds pay dividends - again, a kind of income that is NOT interest...

Bonds behave a little better, but the bond fund that pays 3% this year may pay 1% next year...
Of course bonds pay interest - they have a defined interest rate just like a CD. That there may be default risk doesn't change that. The bond funds interest may be lower next year because as it reinvests in new bonds (to maintain the same term exposure) interest rates may be lower, but that is no different than a CD or savings account.
Please cut me some slack here. I believe you are technically correct for individual bonds, but I was trying to be very simplistic to get the point across. To be honest, I could not tell you the difference between bond dividends and bond interest - I never hear it called interest, at least not with bond funds.

Ok, so I looked it up. Wikipedia says A bond fund or debt fund is a fund that invests in bonds, or other debt securities. Bond funds can be contrasted with stock funds and money funds. Bond funds typically pay periodic dividends that include interest payments on the fund's underlying securities plus periodic realized capital appreciation.

I'll go back and edit my post to only discuss bond funds - like what is in the poster's Target Fund.
I'd generally be happy to cut you some slack - but keeping the distinction between fixed income and equity investments clear seems worth it.

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