Compounding Is Not Only For Interest
For investors, compounding is a wonderful phenomenon. It allows you to earn additional return by earning interest on interest. Furthermore, the more frequently compounding occurs, the incrementally higher the overall return.
Earn Interest on Interest
Let’s say John invests $1,000 in a savings account with 3% annual interest rate.
If the account compounds interest only once per year, at the end of the first year, John would earn $30. In the second year, the 3% interest rate would apply to the $1,000 principal and the $30 interest from the first year.
At the end of Year 2, John’s savings account would be worth $1,060.90 ($1,000 principle plus $60 interest on the principal plus $0.90 interest on the Year-1 $30 interest. The extra $0.90 doesn’t sound like a lot, but if you had a larger principal and longer period of time, the effect of compounding would be larger.
In real life, savings accounts generally compound more than once per year. In the case of monthly compounding, it means that every month, interest would be accredited to John’s account, and that interest would earn interest too going forward.
Since the 3% interest rate is annual, every month the applicable interest rate is actually 3% divided by 12, or 0.25%.
The table shows how the account values would change over a period of ten years, with annual compounding in the middle column and with monthly compounding in the right column. As you can see, each year the account value goes up slightly more with monthly compounding compared to annual compounding.
At the end of ten years, monthly compounding earned you $5.43 extra. Put another way, through monthly compounding, you earned 1.6% more in interest ($349.35 vs. $343.92).
Yes, the difference is small, but if everything else between the two accounts is the same—which it is—then that 1.6% earned through more frequent compounding is literally the proverbial free lunch. Why would you turn down extra return when there’s no extra risk?
Dividend Compounds Too
You may not have thought much about it, but the frequency feature of compounding also carries over to stock dividend. Most U.S. companies pay dividend every quarter, but there are at least five dozen stocks that pay dividend on a monthly basis.
Most of these dividend payers are real estate investment trusts (REITs). They own portfolios of properties that they lease out to tenants and collect rent. Since they tend to have regular monthly rent income, they can turn around and distribute some of that cash flow out to shareholders (technically, unitholders) every month.
There are all kinds of REITs specializing in different industries, such as retail, commercial, industry, office, medical, and so forth. There are even mortgage REITs which specialize in owning mortgages rather than actual real estate.
In any case, if you receive monthly dividend, you can more frequently reinvest that cash into something that earns you a return. As we saw above, the more frequently compounding occurs, the more incremental return you could squeeze out.
Note that if you reinvest the dividend in the same stock or invest it in another stock, it is possible to lose money since stocks can go down. However, since the stock market goes up over the long run, unless you happen to invest in some very bad stocks, reinvesting dividend should result in a positive return over time.
Do Your Homework
Here is where you should practice due diligence. You should not pick a stock solely because it pays a monthly dividend or offers a high yield. An abnormally high yield is usually a red flag that you need to check out the company more to understand why the yield is so high. But if you can find a financially sound company that pays a monthly dividend, you can give yourself the opportunity to earn more return.
Editor’s Note: Scott Chan just explained important investing principles that can help you make money. But does uncertainty in the financial markets have you on edge? The key to mastering risk resides in what our colleague Jim Pearce calls “Mayhem Trades.”
Jim Pearce is chief investment strategist of our premium trading service, Mayhem Trader. Jim has developed an under-the-radar strategy to flip market mayhem into fast payouts. Want to learn more? Click here now.