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Old 02-05-2006, 10:41 AM
pizzabrat pizzabrat is offline
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How does compound interest relate to the stock market

If making money off the stock market is done by buying stock, waiting for that stock price to rise, and then selling it, how does compound interest come into play? Reinvesting the money gained from the sold stock into a completely different, lower priced stock? The prevailing financial advice I've heard is to invest long-term into stocks, not touching them while they grow througout the years; we're also told to take advantage of compound interest when investing . Constantly selling and reinvesting in different stocks to take advantage of compound interest goes against the first strategy. Is there something I'm missing?
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Old 02-05-2006, 11:22 AM
RandomLetters RandomLetters is offline
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Basically, the value of a (good) stock will steadly grow over the years, effectively acting like compound interest. IE, if you invested $1,000 and your stock averages a 10% gain every year, after 1 year you would have $1,100 worth of stock, after 2 years you would have $1,210, $1,331 after 3 years, and so on. Let the stock sit for 50 years, and it will be worth $117,390.85.
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Old 02-05-2006, 11:35 AM
Duckster Duckster is offline
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Quote:
Originally Posted by pizzabrat
Is there something I'm missing?
Yes.

The company can declare a dividend. Instead of taking that dividend as cash you use it to buy more stock. Also, a stock can split. While the initial value of your holding remains the same during a split, the value will rise faster when the stock price begins to climb again.
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Old 02-05-2006, 12:48 PM
RealityChuck RealityChuck is offline
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Good stocks generally increase in value over time, but it isn't compound interest. Dividends do help, but many stocks do not pay dividends, and dividends are often looked at as money that could be better spent growing the business and improving the stock price.

The issue is that stock prices have generally paid better than interest, especially today, when interest rates are low. Compound interest is safer, but stocks give you greater returns, and I don't think the "magic of compound interest" was intended to apply to stock.
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Old 02-05-2006, 04:22 PM
HMS Irruncible HMS Irruncible is offline
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Quote:
Originally Posted by pizzabrat
If making money off the stock market is done by buying stock, waiting for that stock price to rise, and then selling it, how does compound interest come into play? Reinvesting the money gained from the sold stock into a completely different, lower priced stock? The prevailing financial advice I've heard is to invest long-term into stocks, not touching them while they grow througout the years; we're also told to take advantage of compound interest when investing . Constantly selling and reinvesting in different stocks to take advantage of compound interest goes against the first strategy. Is there something I'm missing?
People who hype stocks as the supreme investment vehicle sometimes like to cite the 11% average annual growth in the S&P500 since its inception, and then compute the returns as if it were a deposite account with an 11% interest rate, which isn't really honest or accurate and elides the risk involved.

However, If you were to buy stocks that paid dividends, and then always reinvested the dividends in the same stock, and the price of the stock never changed over time, that would look something like interest. On average, of course, stocks have gone up. And some stocks have had such a consistent gradual rise in spite of all setbacks that they're virtually like money in the bank. Some of these companies have DRIP (divident re-investment programs) where, with your permission, they automatically take your dividend money and buy more stick with it. So if you're the owner of a growing stock then bascially your arrangement looks a lot like compound interest, and potentially a lot better. These won't be high-flying internet stocks, but I trust we all appreciate why those aren't always the way to go.

(Disclaimer, I invest in stocks, I just don't like people who hard-sell them to people who don't yet fully understand investing).
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