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Subject:  Re: Returns and Compounding=confused! Date:  4/22/1999  10:16 AM
Author:  TMFSelena Number:  78 of 2238

<< I know this is a basic question but I haven't really found it explained so that I understand it. I understand the concept of compounding but don't understand how returns work.

Well, they're not unrelated to each other. Let me try to explain. (If I misstate anything, someone please speak up.)

If you buy stock for $100 and five years later it's valued at $176, it's gone up 76%. You've got a 76% 5-year total return. You can annualize that, though, determining that you earned the equivalent of 12% per year to get the total 76%. Another way of thinking about that is that your investment earned a compounded 12% return over the period.

If your 12% return was not compounded (and now, we've moved further into the theoretical realm, and are not really talking about a specific stock you bought), then your $100 investment would simply earn the same 12% per year. 12% would mean $12 per year, for a total of $60 in five years and a total end result of $160 -- a total 60% return.

You're right, that in a sense, compounding is continual reinvesting, and by holding your stock for the long term, you're not selling and rebuying it. But you can still think of your returns in compounding terms. It's a way of visualing/conceptualizing how money grows.

Because if you started with $100 of a stock and now it's worth $150, if it goes up 3%, it's going up 3% from $150, not from your initial $100. Your base keps growing. In a sense, compounding is at work.

(I fear I may have created more confusion instead of clarifying things!)

Cheers -

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