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If you reinvest your gains then you realize the power of compounding. Your principal value on which you earn a growth percentage grows, so even if the % growth stays the same the dollar amount you realize is greater
When you say reinvest your gains, these have to be either realized gains from selling said index fund or dividend gains from the fund right? And if we’re thinking about the concept of compounding it’d just have to be the reinvestment of dividends then right?
So I guess to follow up, the question becomes: are the two factors that show the power of compounding, (1) reinvestment of dividends, and (2) reliance on S&P 500 7%+ annual growth that will allow this reinvestment to multiply?
If that’s the case, it certain seems that when people discuss compounding interest, especially for a Roth IRA, they don’t focus enough on the fact that this compound interest is ESSENTIALLY driven by the reinvestment of dividends received.
You do not need to realize gains from investment returns to benefit from compounding interest.
Example...
At the start of year 1 you invest $100, by the end of the year, you have a 10% return ($10)
At the start of year 2, you now have $110 and do not invest again. By year end, about 10% return ($11)
At the start of year 3, you have $121. Your investment gains are returning compounded interest on top of your principal. If you funds also pay out dividends, you will want to reinvest those dividends as well.
If you purchase 1 share of company A at $100/share at the beginning of year 1 and the price increases by 10% by year end, the total account value is $110. If the share increases by 10% again during year 2, the account value is $110*(1+0.1)=$121. Do this for 20 years and you can see how that grows.
Why do you want such a heavy dividend allocation? 50% dividend aristocrats wouldn't make sense unless you're close to retirement
Rising Star
Interest compounding is unrealized gains reinvested. So, let’s say, your EFT in Roth has a 7.5% gain & you’ve been reinvesting gains—the next year you’d have starting capital + 7.5% (unrealized gains) growing at the next years %.
Do that YoY and that’s the compounding. As folks have pointed out—you do not have to sell/realize gains to compound.
But yes—it makes sense to both compound and take dividends tax free so long as the dividend stocks are also growing .
Thank you guys for the explanations, definitely makes sense. I guess I was just having trouble imagining that there would be consistent returns that average out to atleast 7% on annual basis, although the S&P 500 has proven out over so many years lol
There’s so much content, esp finance YouTube channels, that advertise opening a Roth IRA early on and capitalizing on compound interest, which is absolutely the right thing to do. However none really dive in mechanics of the compound interest and how it’s to be realized 25-40 years down the road. Thoughts?