How Can Investors Receive Compounding Returns?
Compound returns refer to the way investment gains can potentially multiply over time. In this way, compound returns can add to your principal. The larger principal amount would potentially see higher gains — helping you to build your wealth, assuming the gains are reinvested.
Compound returns depend on the investment’s rate of return — meaning how much the investment gains or loses value over time. The effects of compounding returns typically occur over a period of years, because most investments see gains and losses; for gains to compound it takes time.
That’s why people are often encouraged to start investing at an early age, even with small amounts. The longer their money is invested, the more compounding it may see.
Key Points
• Compounding is a phenomenon where returns on investment principal can accumulate, and thus potentially see even larger gains over time.
• This is similar to the way compound interest works with some types of bonds.
• Compound returns are not guaranteed in an investment portfolio. Investing includes the risk of loss.
• Stocks that pay dividends offer a type of compounding when reinvested in more of the same stock.
• Types of investments that may see compound returns over time include stocks, certain savings bonds, mutual funds, and exchange-traded funds (ETFs).
What Are Compound Returns?
Returns are the earnings you see on an investment; compound returns are the gains that accumulate on top of those gains, which can accelerate your investment’s growth.
Compound returns can be achieved by any type of asset class that produces returns on both the initial amount–the principal–as well as any profits or returns that are generated after the initial investment. Essentially, the money you put to work is doing additional work automatically for you.
Essentially, the money you put to work is doing additional work automatically for you.
However, in the case where an investor sees a series of losses, that would curtail the compounding process. All investments are subject to the risk of loss.
How Does Compound Interest Work?
Compound interest, on the other hand, refers to interest that accrues on certain types of bonds, which pay a fixed amount of interest in the form of coupon payments, which gets added to the original principal amount.
There isn’t such a thing as compound interest with stocks. But some stocks pay dividends, which can be reinvested in more shares of stock as well — which is also a type of compounding.
The Value of Compound Returns
Here’s a hypothetical example that illustrates the idea of compound returns. (However, be aware that this is only for an investor making profits. In reality, an investor could also experience losses.)
Let’s say an investor buys shares of a stock that costs $1,000. That’s the principal. In the first year, they earn a 10% return. The stock is now worth $1,100. Things start to get interesting in the second year, when the stock increases in value another 10%, bringing the stock’s value to $1,210.
That’s $110 in profit earned in the second year, compared to $100 in the first year. This happened even though the investor did not add any additional money to the investment, and they earned the same rate of return. The investment simply grew over the previous year, creating a larger base from which to earn more.
If the investor were to earn a 10% rate of return the third year, the profit would be even greater than in the previous two years. Working off a larger base — now $1,210 — a 10% return will yield a profit of $121.
But keep in mind that investments like stocks may experience volatility. Take the example from above. Three consecutive years of 10% returns is highly unlikely. In fact, it’s also possible for investors to lose money on their investments, which is the case in almost any asset class.
Recommended: A Beginner’s Guide to Investing in Your 20s
How to Get Compound Returns
With compound returns, the reinvestment of gains may be done automatically or manually.
Here are some examples of investment types that can earn compound returns.
Stocks: First, some stock market basics. There are two ways to make money on a stock. The first is through price appreciation, and the second is through dividend payments, as noted above.
When the value of a stock grows over time, an investor has the potential to see compound returns if those profits are reinvested. With cash dividend payments, compound returns are not automatic — except in the case of a dividend reinvestment plan (DRIP) — as they are paid out in cash, but an investor can add the payouts back in order to potentially earn additional returns.
Mutual funds: Mutual funds are large, pooled portfolios of stocks, bonds, or other securities. For example, a mutual fund could invest in the U.S. stock market by including stocks from a specific index. Over time, the goal is that the mutual fund grows as the underlying investments grow.
Many mutual funds that include dividend-paying stocks give the option of automatic dividend reinvestment plans. This way, the investor can earn compound returns in both ways, on the price appreciation and the dividend payments.
Exchange-traded funds (ETFs): Similar to mutual funds, ETFs are pooled investments, like stocks. As the value of the ETF grows over time, returns will compound. Depending on which bank or institution where the ETF is purchased, it may or may not be possible to automatically reinvest dividends.
Remember, with all investments, a good return on investment is not guaranteed, even profits aren’t. Plus, investments that tend to earn a higher potential return may also come with higher risk.
💡 Quick Tip: How to manage potential risk factors in a self-directed investment account? Doing your research and employing strategies like dollar-cost averaging and diversification may help mitigate financial risk when trading stocks.
Which Products Offer Compound Interest?
Some types of accounts earn compound interest. For example:
• High-yield savings accounts
• Money market accounts (MMAs)
• Certificates of Deposit (CDs)
With these types of accounts, the money you deposit typically earns a fixed amount of interest that typically compounds over time.
Test your understanding of what you just read.
The Takeaway
Compound returns can be a powerful way for your money to grow over time. When you invest your money in stocks or other asset classes, you have the potential to earn compound returns (although there is no guarantee, as investments include the risk of loss). And the longer you invest, the more time your returns may have to compound.
Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).
FAQ
Do stocks compound daily?
No, the value of stocks — the rise and fall of the price per share — changes frequently over time, but it does not compound. Stocks may deliver compound returns in that returns can accumulate, adding to your portfolio’s growth, but there are no guarantees.
What is the average compound interest return?
The average compound interest return depends on the types of savings vehicles you have. Be sure to check, as some accounts offer higher rates than others.
What is the difference between arithmetic and compounding returns?
With arithmetic returns, you take the difference between the ending value of an investment and the beginning value of the investment and divide it by the beginning value. Compound returns depend on the rate of return–meaning how much an investment gains or losses over time.
INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
For disclosures on SoFi Invest platforms visit SoFi.com/legal. For a full listing of the fees associated with Sofi Invest please view our fee schedule.
Exchange Traded Funds (ETFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or by emailing customer service at [email protected]. Please read the prospectus carefully prior to investing.
Mutual Funds (MFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or clicking the prospectus link on the fund's respective page at sofi.com. You may also contact customer service at: 1.855.456.7634. Please read the prospectus carefully prior to investing.Mutual Funds must be bought and sold at NAV (Net Asset Value); unless otherwise noted in the prospectus, trades are only done once per day after the markets close. Investment returns are subject to risk, include the risk of loss. Shares may be worth more or less their original value when redeemed. The diversification of a mutual fund will not protect against loss. A mutual fund may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.
Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.
Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
Third Party Trademarks: Certified Financial Planner Board of Standards Center for Financial Planning, Inc. owns and licenses the certification marks CFP®, CERTIFIED FINANCIAL PLANNER®
SOIN-Q225-062
