How does the compound interest concept vary between a basic savings account and an index fund?
I understand compound interest as it relates to a basic savings account. If you get 5% interest on $1000 each year, it will be worth $1,050 at the end of the year, as $50 in interest was added. Over time it will keep compounding. Investing $1,000 in an S&P index fund will go up and down, which is not exactly the same as compounding. It may go up way more than 5%, but can that really be considered compound interest?
Compounding really refers to earning money on the money that comes from an investment. It’s easy to understand with things, like CDs, that pay a fixed amount of interest each year. But with a stock or a mutual fund you need to be able to distinguish between changes in share value and the change in the number of shares you own due to dividends or interest payments that go into buying more shares.
In the case of a mutual fund where distributions are reinvested in more shares, compounding does work since each added share will be earning more dividends and capital gains. Where it gets confusing is that this compounding can be masked by changes in share value, either up or down.
So, from my perspective, compounding does apply to a both a mutual fund and a savings account but the math to determine the rate of return is much more complicated.
The concept of compound interest really only applies to interest bearing investments that permit the reinvestment of interest. If an investment (e.g. savings bonds, certificate of deposit) pays periodic interest that is reinvested to earn more interest, the investment may be said to be earning compound interest.
Investments such as index funds and stocks do not pay interest. Over time the value of the investment may grow (or decline) and its return may be expressed as an effective compound rate of return (e.g. equivalent to an savings account paying X% compounded annually). The reinvestment of dividends from an index funds (or stock) may be considered a form of compounding, but, over time, the total return will be determined by the combination of dividends + appreciation. Because long term index returns have generally been strong over longer periods of time and are often expressed in terms of compound annualized rates of return, it has led to the misperception that they actually pay compound interest. For a 10- year stretch from 2000-2009, the S&P 500 index actually had a negative rate of return. This serves to illustrate how Einstein's "Miracle of Compounding" is not necessarily applicable to stocks. Today, with interest rates on fixed income investments near historic lows, the concept of compound interest seems like a quaint artifact of a bygone era.
For further support of this perspective, see the following articles -
Thanks for a fun question!