What Is Compounding In Saving And Investing?

Back to basics in today’s installment of The Juice to tie together a topical personal finance and investing theme we have been hammering hard lately. 

The ongoing quest for income generation on your cash and investments, particularly as the Federal Reserve prepares to — most likely — lower interest rates in September. 

In Is It Time To Lock In Those 5% Interest Rates On Your Cash?, we covered the ins and outs of what might happen with interest rates on savings:

All of this said, given the Fed decision on the horizon, how quickly will savings rates fall and, subsequently, should you lock in a rate on a long-term CD?

There’s no way to know for sure, but the consensus is that, when the Fed starts to cut, so will the banks. Even the online names. So, the prevailing advice is to lock in long-term CD rates now if you don’t mind having your money tied up. If you do, keep milking the HYSA rates, but don’t expect them to last. And, remember, HYSA aren’t something you can lock in. You have to ride and choose to accept — or not — the ups and downs. 

For the record, the yield on a 10-year Treasury note is already falling. Long down from its April high, last week it dipped just under 4.0%.

And, in This Is The Perfect Stock Market For Solid Dividend Stocks, we discussed why some investors might move some cash into dividend payers ahead of the aforementioned rate cuts:

We don’t think it makes a ton of sense to rotate in and out of sectors or types of stocks if you’re a long-term investor. That’s not long-term investing. That’s market timing. 

Of course, you might keep a bit more cash in the bank when rates are high and buy the dip when your favorite stocks correct. But you should own the broad market, higher risk/big reward stocks and solid dividend stocks (including consumer defensive names) all of the time.

Keeping our fingers on the pulse, it makes sense to really highlight the power of compounding. Because, whether you do it in a savings account, CD, dividend stock or something else entirely, it’s not just about generating income. It’s about the amplifying effects of watching — generally — your interest earn interest.   

So, you put $10,000 in a savings account. Next month, interest ups that $10,000 to, say, $10,050. So, now you’re earning interest on $10,050. That $10,050 morphs into $10,102 the following month. Now, you’re earning interest on $10,102. Through it all, you did nothing other than let your money breathe. 

Compounding. 

Or you buy a dividend stock. Fifty shares. You receive a quarterly dividend of $0.10 per share. That’s $5.00. You reinvest it into more shares of the stock increasing your position size. Now, you receive your dividend payment based on that increased number of shares. Rinse and repeat quarterly. 

That’s dividend reinvestment. One form of compounding in investing. 

There’s nothing like it. Even in a cash account. Seeing your balance increase without even making additional contributions. 

So let’s highlight it. 

That $10,000. Over the last little while you can easily score a risk-free 5% interest rate. Even higher in more than a few places. 

• Put that $10,000 under your mattress and, in a year, it’s still $10,000. 
• Put it in a deposit account with a 5% APY a year ago and today you have approximately $10,511.62. 

Let’s say you managed to maintain that 5% APY for five years. At the end of five years, you would have about $12,833.59. With no intervention. Amazing. 

It’s even more powerful with dividend stocks and ETFs. 

Let’s say that 10 years ago you had the bright idea to put $10,000 each into Apple (AAPL), which is the second most popular dividend stock among financial pros right now in our Trackstar database, and the SPDR S&P 500 ETF (SPY). 

Without dividend reinvestment:

• Your AAPL investment grew to $114,090. 
• Your SPY investment grew to $32,208. 

WITH dividend reinvestment: 

• Your AAPL investment grew to $126,082.
• Your SPY investment grew to $35,172. 

We’re talking a difference of nearly $15,000.

That’s a lot of money. And the effects only multiply exponentially over time. 

Go back twenty years and the difference in SPY alone — between reinvesting and not reinvesting dividends — is nearly $15,000. We didn’t run the same math on AAPL given that it has only been paying a dividend for the last 13 years after taking a break from dividend paying for quite some time. 

However you slice it, you’re better off earning interest and reinvesting dividends. 

The Bottom Line: If you consume financial media, you read a lot about how to buy stocks that will soar now. Or related content. We’re all for it. That’s part of the fun of being an investor. Going for big wins. And you can make money — often lots of it — this way. Just think about having been in Nvidia (NVDA), as one just one example, over the last one or two years.  

This said, most people get wealthy and maybe even rich over the long haul. Add regular contributions to your savings and investments and compounding can literally take on a life of its own. It’s the most realistic path to financial freedom for most everyday savers and investors.

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