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Question about compounding returns on stocks.

  • 14-07-2020 8:10pm
    #1
    Registered Users Posts: 1,256 ✭✭✭ JackieChang


    WARNING: I am a noob at this.

    I'm having a back and forth with a friend about compounding returns on stocks.

    He said you need to sell your gains and buy back in, otherwise unrealised gains "don't mean sh!t" (his words)

    I said leaving your unrealised gains untouched will add to the compounding effect.

    Then he said that the "unrealised gains is just a number on a screen and unrealized. If you want to earn money from your profit, you need to realise the profit and then reinvest it."

    That doesn't make any sense whatsoever. So from now until I'm 95 years old I have to constantly sell my profit and buy back in? According to him, yes.

    So I basically did a "Jimmy went to the shop" hypothetical scenario.

    Invest $100 in a stock that is guaranteed to go up 30% per year.

    Year 1: $130 (+ 30% of $100)
    Year 2: $169 (+30% of $130)
    Year 3: $219 (+30% of $169)
    etc. etc

    He said it doesn't work like that. You have to cash out your profit, and buy back in to get compounding returns. If you don't cash out, he said it will be:

    Year 1: $130 (+ 30% of $100)
    Year 2: $160 (+30% of $100)
    Year 3: $190 (+30% of $100)
    etc. etc

    The gains will only be on the original $100.

    The unrealised gains "only exist theoretically until you cash out and reinvest them" according to him.

    He is absolutely convinced that 1,000 websites and other people I've asked about compounding are wrong.

    So what the hell is he smoking? It doesn't make an ounce of sense. Is he on about some other form of compounding?


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Comments

  • Registered Users Posts: 2,114 ✭✭✭ PhilOssophy


    I think there is a Revenue rule that says you have to cash out every 8 years? Which I think (but do not know) means the gain made in the 8 years is subject to CGT.
    Don't take my word though, it is something along those lines I think. Some others will know better I reckon!


  • Registered Users Posts: 1,256 ✭✭✭ JackieChang


    I think there is a Revenue rule that says you have to cash out every 8 years? Which I think (but do not know) means the gain made in the 8 years is subject to CGT.
    Don't take my word though, it is something along those lines I think. Some others will know better I reckon!

    Pretty sure that's only for ETFs.


  • Registered Users Posts: 2,114 ✭✭✭ PhilOssophy


    Pretty sure that's only for ETFs.

    Actually yeah I think you are right now that I think of it! Sorry!


  • Registered Users Posts: 277 ✭✭ kapisko1PL


    I'm speaking from my own experience since I've owned and sold some stocks before.

    If I understand your question correctly;

    Let's say you buy a stock for €100 and it goes up by 50% to €150. Now, great, your initial investment is now worth 50% more. But, it doesn't mean anything if the stock falls back to €100. Then you have no profit. BUT, if you cashed in at €150 and sold your share and the stock fell back to €100 youd have made an actual €50 profit. Now you can buy in again at €100 and hope the stock goes back to €150 and sell again. That's how your make profit. If you don't cash in at some stage, you'd just be going up and down without actually having any cash at your disposal.


  • Registered Users Posts: 1,256 ✭✭✭ JackieChang


    kapisko1PL wrote: »
    I'm speaking from my own experience since I've owned and sold some stocks before.

    If I understand your question correctly;

    Let's say you buy a stock for €100 and it goes up by 50% to €150. Now, great, your initial investment is now worth 50% more. But, it doesn't mean anything if the stock falls back to €100. Then you have no profit. BUT, if you cashed in at €150 and sold your share and the stock fell back to €100 youd have made an actual €50 profit. Now you can buy in again at €100 and hope the stock goes back to €150 and sell again. That's how your make profit. If you don't cash in at some stage, you'd just be going up and down without actually having any cash at your disposal.

    Doesn't that go against the whole buy and hold mantra?

    Your method is "timing the market" vs "time in the market". How do you know when to cash out? What if I cash out, and the stock shoots up 10%?

    I'll have missed out on those gains.

    Anyway it seems your post is more about day trading, I'm just talking about long term compounding exponential growth.


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  • Registered Users Posts: 277 ✭✭ kapisko1PL


    It's very hard to predict how the stock market is going to behave. Look at it now, it's unreasonable. World economy has taken a hit like it has not done so in a long time yet the market is booming.

    There are some methods that help the analytics predict it's behaviour such as the wedge patterns or three bar rules (should not be used as an accurate guide, more of a bare indication).

    If you don't cash out at some stage, you're going to be in a possession of a stock that has no actual cash value, per se. If you bought Tesla 2 years ago and cashed it today, you'd have made some serious cash gains. Two years is not day trading.

    Buying at 100 and selling at 150 and then buying back in at 150. Yes you've made 50 quid but what's the point of reinvesting the 50 quid back into the stock which is the same price you sold it for? If you don't cash out at some stage, either or is going to happen: the stock market is going to crash at some stage again in the future and your shares will be worth a lot less or you cash in at some stage and take your profits. Otherwise you'd be waiting for ever to cash out without seeing any profits. Expect those green bars on your brokerage screen that you've made but didn't cash.


  • Registered Users Posts: 807 ✭✭✭ Jimbobjoeyman


    WARNING: I am a noob at this.

    I'm having a back and forth with a friend about compounding returns on stocks.

    He said you need to sell your gains and buy back in, otherwise unrealised gains "don't mean sh!t" (his words)

    I said leaving your unrealised gains untouched will add to the compounding effect.

    Then he said that the "unrealised gains is just a number on a screen and unrealized. If you want to earn money from your profit, you need to realise the profit and then reinvest it."

    That doesn't make any sense whatsoever. So from now until I'm 95 years old I have to constantly sell my profit and buy back in? According to him, yes.

    So I basically did a "Jimmy went to the shop" hypothetical scenario.

    Invest $100 in a stock that is guaranteed to go up 30% per year.

    Year 1: $130 (+ 30% of $100)
    Year 2: $169 (+30% of $130)
    Year 3: $219 (+30% of $169)
    etc. etc

    He said it doesn't work like that. You have to cash out your profit, and buy back in to get compounding returns. If you don't cash out, he said it will be:

    Year 1: $130 (+ 30% of $100)
    Year 2: $160 (+30% of $100)
    Year 3: $190 (+30% of $100)
    etc. etc

    The gains will only be on the original $100.

    The unrealised gains "only exist theoretically until you cash out and reinvest them" according to him.

    He is absolutely convinced that 1,000 websites and other people I've asked about compounding are wrong.

    So what the hell is he smoking? It doesn't make an ounce of sense. Is he on about some other form of compounding?

    Your pals wrong and your right.


  • Registered Users Posts: 299 ✭✭ Live at Three


    I have wondered this same thing myself. When people talk about the wonder of compounding they make it sound like a given. However, I always wonder how it applies when you don't realise the profits.

    It is certainly a very simple concept when you think about a guaranteed interest rate on a deposit, you can sit back and watch percentages compounding on top of percentages - but with stocks this is not guaranteed.

    The other way I look at it is that the value of the whole stock market generally rises with inflation, and this corresponds with a the guaranteed interest scenario. It is probably reasonable.to assume that an index like the S&P 500 will be worth more in 20 years' time than it will now. This doesn't help with individual stock picking though.

    I think compounding in the stock market isn't always the wonder of the world some would make it out to be.

    Your premise is right but a crucial part of your OP is the phrase "guaranteed return of 30%"
    No stock has a guaranteed return so in a way your friend is right to say that it doesn't work like that.


  • Registered Users Posts: 1,899 ✭✭✭ ronivek


    There is no inherent compounding in owning stocks. The stocks gain or lose value based on any number of factors; but it's not due to some intrinsic compounding rule or law. If the market or stock is having a good run it will gain in value.

    Now what you might be doing is reinvesting your dividends back into the stock; in which case yes a form of compounding is taking place. In that case you would be compounding your dividend gains quarterly. Some brokerages will do this automatically on your behalf and some you will need to request they do it; otherwise it will just be sitting in your account as cash.

    It would seem like as you suggested your friend is talking more about timing the market to continuously try and realise gains; which doesn't really make any sense. Especially when you consider that these kinds of transactions also incur fees which you otherwise would not incur.


  • Registered Users Posts: 2,069 sunnysoutheast


    WARNING: I am a noob at this.

    I'm having a back and forth with a friend about compounding returns on stocks.

    He said you need to sell your gains and buy back in, otherwise unrealised gains "don't mean sh!t" (his words)

    I said leaving your unrealised gains untouched will add to the compounding effect.

    Then he said that the "unrealised gains is just a number on a screen and unrealized. If you want to earn money from your profit, you need to realise the profit and then reinvest it."

    That doesn't make any sense whatsoever. So from now until I'm 95 years old I have to constantly sell my profit and buy back in? According to him, yes.

    So I basically did a "Jimmy went to the shop" hypothetical scenario.

    Invest $100 in a stock that is guaranteed to go up 30% per year.

    Year 1: $130 (+ 30% of $100)
    Year 2: $169 (+30% of $130)
    Year 3: $219 (+30% of $169)
    etc. etc

    He said it doesn't work like that. You have to cash out your profit, and buy back in to get compounding returns. If you don't cash out, he said it will be:

    Year 1: $130 (+ 30% of $100)
    Year 2: $160 (+30% of $100)
    Year 3: $190 (+30% of $100)
    etc. etc

    The gains will only be on the original $100.

    The unrealised gains "only exist theoretically until you cash out and reinvest them" according to him.

    He is absolutely convinced that 1,000 websites and other people I've asked about compounding are wrong.

    So what the hell is he smoking? It doesn't make an ounce of sense. Is he on about some other form of compounding?

    Compounding returns on stocks usually refers to reinvestment of dividends.

    Might be worth reading up on the difference between Accumulation and Income units. That's the basic principle.


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  • Moderators, Business & Finance Moderators Posts: 7,827 Mod ✭✭✭✭ Jim2007


    He said you need to sell your gains and buy back in, otherwise unrealised gains "don't mean sh!t" (his words)

    I stopped at this point because clearly your friend is absolutely clueless and you should stop having these kinds of conversation with him.


  • Moderators, Business & Finance Moderators Posts: 7,827 Mod ✭✭✭✭ Jim2007


    kapisko1PL wrote: »
    I'm speaking from my own experience since I've owned and sold some stocks before.

    If I understand your question correctly;

    Let's say you buy a stock for €100 and it goes up by 50% to €150. Now, great, your initial investment is now worth 50% more. But, it doesn't mean anything if the stock falls back to €100. Then you have no profit. BUT, if you cashed in at €150 and sold your share and the stock fell back to €100 youd have made an actual €50 profit. Now you can buy in again at €100 and hope the stock goes back to €150 and sell again. That's how your make profit. If you don't cash in at some stage, you'd just be going up and down without actually having any cash at your disposal.

    This is called timing the market and should be avoided like the plague.


  • Moderators, Business & Finance Moderators Posts: 7,827 Mod ✭✭✭✭ Jim2007


    I'm having a back and forth with a friend about compounding returns on stocks.

    There is no compounding what's so every in this. You by a share of a company, a business that will hopefully will grow and expand over time and be come more valuable. It's stock price represent the the value of the company today, nothing else...


  • Registered Users Posts: 1,256 ✭✭✭ JackieChang


    Jim2007 wrote: »
    There is no compounding what's so every in this. You by a share of a company, a business that will hopefully will grow and expand over time and be come more valuable. It's stock price represent the the value of the company today, nothing else...

    There's no compounding in my version or his version?

    Many website mention compounding returns on stocks. For example:

    Compounding is based on the idea that, when you earn interest and generate earnings on your investments, the next year you earn interest on your original investment, plus the interest from the first year. And on and on it goes.

    The longer you invest, the more time there is for compound interest to take effect.


    From: https://www.investments.halifax.co.uk/boost-your-skills/develop-your-skills/buy-and-hold

    Another article on compounding:

    "But look a little deeper at the effect of selling versus holding, and you see that the effect of holding stocks and not selling is to vastly increase the portfolio size over time."

    More:

    "If you keep your money invested for a long enough time frame, it becomes possible to not only make gains on the initial investment, but also on previously made returns. The compound interest creates a snowball effect; the longer the money is left invested, the more your initial investment will increase year after year."

    And a million other websites etc etc


  • Registered Users Posts: 299 ✭✭ Live at Three


    There's no compounding in my version or his version?

    Many website mention compounding returns on stocks. For example:

    Compounding is based on the idea that, when you earn interest and generate earnings on your investments, the next year you earn interest on your original investment, plus the interest from the first year. And on and on it goes.

    The longer you invest, the more time there is for compound interest to take effect.


    From: https://www.investments.halifax.co.uk/boost-your-skills/develop-your-skills/buy-and-hold

    Another article on compounding:

    "But look a little deeper at the effect of selling versus holding, and you see that the effect of holding stocks and not selling is to vastly increase the portfolio size over time."

    More:

    "If you keep your money invested for a long enough time frame, it becomes possible to not only make gains on the initial investment, but also on previously made returns. The compound interest creates a snowball effect; the longer the money is left invested, the more your initial investment will increase year after year."

    And a million other websites etc etc

    The above quotes talk about compounding on the 'returns' from stocks. Usually the only way to make return from a stock is to sell it for a profit, or earn a dividend.


  • Registered Users Posts: 11,386 ✭✭✭✭ Timmaay


    The only reason compounding gets highlighted in terms of regular savings accounts is people all the time do the wrong maths of let's say your offered 5% return per year, and you want to leave your money there for 10yrs and you go oh that's 5% x 10 or 50% interest, which obviously isn't taking into account the addition of interest every year, you actually end up with a 61% return in the above figures. Compounding doesn't apply to the stock market because there is no fixed yearly interest rate whatsoever.


  • Registered Users Posts: 2,069 sunnysoutheast


    There's no compounding in my version or his version?

    Many website mention compounding returns on stocks. For example:

    Compounding is based on the idea that, when you earn interest and generate earnings on your investments, the next year you earn interest on your original investment, plus the interest from the first year. And on and on it goes.

    The longer you invest, the more time there is for compound interest to take effect.


    From: https://www.investments.halifax.co.uk/boost-your-skills/develop-your-skills/buy-and-hold

    Another article on compounding:

    "But look a little deeper at the effect of selling versus holding, and you see that the effect of holding stocks and not selling is to vastly increase the portfolio size over time."

    More:

    "If you keep your money invested for a long enough time frame, it becomes possible to not only make gains on the initial investment, but also on previously made returns. The compound interest creates a snowball effect; the longer the money is left invested, the more your initial investment will increase year after year."

    And a million other websites etc etc

    I think it was Einstein who said compound interest was the 8th wonder of the world.

    The equivalent principle with equity investment is the reinvestment of the dividends received over time into further purchases of stock, which is where the compounding effect comes in.

    Obviously the stock price will be subject to the vagaries of the market, and dividends aren't guaranteed.

    I think your friend might be talking about taking advantage of short-term gains in stock prices to realise a profit, kind of the opposite of long-term passive buy-and-hold.


  • Moderators, Business & Finance Moderators Posts: 7,827 Mod ✭✭✭✭ Jim2007


    Usually the only way to make return from a stock is to sell it for a profit, or earn a dividend.

    Not at all. The best option is to invest in a business that continues to grow by reinvesting the retained earnings in the business, thus increasing the value of the rather that paying dividends.

    There are really only two justifications for paying a dividend:
    - You can't find investment opportunities within the business that will deliver a return better than what the shareholder can obtain themselves
    - You are a pension stock: your shareholders hold the stock for an income.


  • Registered Users Posts: 299 ✭✭ Live at Three


    Jim2007 wrote: »
    Not at all. The best option is to invest in a business that continues to grow by reinvesting the retained earnings in the business, thus increasing the value of the rather that paying dividends.

    There are really only two justifications for paying a dividend:
    - You can't find investment opportunities within the business that will deliver a return better than what the shareholder can obtain themselves
    - You are a pension stock: your shareholders hold the stock for an income.

    But how do you get a return from a stock without selling it?


  • Registered Users Posts: 1,225 ✭✭✭ Kilboor


    But how do you get a return from a stock without selling it?

    You're talking about the fundamentals of investing and finance. You buy a share (an asset) and it increases or decreases in value, and likewise your net worth correlates to this change . It's up to YOU to decide when to sell or buy.

    You can't make any cash return unless you sell it (dividends aside).


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  • Registered Users Posts: 299 ✭✭ Live at Three


    Kilboor wrote: »
    You can't make any cash return unless you sell it (dividends aside).

    Agreed.


  • Registered Users Posts: 1,225 ✭✭✭ Kilboor


    Agreed.

    To be clear, I said cash return. You can make a net value return (what Jim is eluding to) if the underlying asset i.e. the business reinvests earnings and grows.


  • Registered Users Posts: 1,256 ✭✭✭ JackieChang


    But how do you get a return from a stock without selling it?

    I sell it in 20 years and then get my return. What I'm getting at is long term investing. Why do I have to sell and buy back constantly to see compounding growth? What a pain in the arse.

    Why can't I hold for 20 or 30 years and grow my investment?


  • Registered Users Posts: 1,225 ✭✭✭ Kilboor


    I sell it in 20 years and then get my return. What I'm getting at is long term investing. Why do I have to sell and buy back constantly to see compounding growth? What a pain in the arse.

    Why can't I hold for 20 or 30 years and grow my investment?

    You can definitely hold your investment 20 years. It's not compounded though, why would it be? You're buying an asset, imagine it to be something physical. The value of that asset increases so your net worth increases.

    I'm a little confused as to exactly what you're asking for. Maybe some investing strategies would help you more. You don't have to lump all your available money into a stock straight away.


    https://www.investopedia.com/terms/d/dollarcostaveraging.asp


  • Registered Users Posts: 299 ✭✭ Live at Three


    I sell it in 20 years and then get my return. What I'm getting at is long term investing. Why do I have to sell and buy back constantly to see compounding growth? What a pain in the arse.

    Why can't I hold for 20 or 30 years and grow my investment?

    Don't get me wrong, I am in no way suggesting that you should sell anything constantly. That involves trying to time the market, and adds up fees. I'm just trying to get to the root of the question which I believe revolves around that word 'returns'.

    I agree with all of the above posts and I'm not suggesting any strategy. My issue is with the way websites and other sources sell compounding as a wonder of the world without going into all the nuances which we have gone through above. It is very easy to tell someone that a guaranteed interest rate will add up to mind-blowing exponential growth, and it's very easy to show sums that explain this..but the reality with stocks is not that simple.


  • Registered Users Posts: 1,899 ✭✭✭ ronivek


    I sell it in 20 years and then get my return. What I'm getting at is long term investing. Why do I have to sell and buy back constantly to see compounding growth? What a pain in the arse.

    Why can't I hold for 20 or 30 years and grow my investment?

    Many people have chimed in to state your friend is wrong; you don't need to sell and buy back constantly.

    The only open questions I would have in relation to you holding the stocks for 20+ years are:
    • What type of stock is it; is it just a simple stock in something like Tesla or Amazon?
    • Is the stock paying any dividends or not?
    • Where are you holding the stocks?

    The only compounding aspect that you have personal control over is what happens to any cash dividends; once you've figured that bit out you can rest easy.


  • Registered Users Posts: 1,225 ✭✭✭ Kilboor


    Don't get me wrong, I am in no way suggesting that you should sell anything constantly. That involves trying to time the market, and adds up fees. I'm just trying to get to the root of the question which I believe revolves around that word 'returns'.

    I agree with all of the above posts and I'm not suggesting any strategy. My issue is with the way websites and other sources sell compounding as a wonder of the world without going into all the nuances which we have gone through above. It is very easy to tell someone that a guaranteed interest rate will add up to mind-blowing exponential growth, and it's very easy to show sums that explain this..but the reality with stocks is not that simple.

    To be clear though, the S&P500 has an average yearly growth of 8%. Many websites sell this as the compounding factor, i.e. after year 2 the 8% gain will be on the principle + year 1s growth/return


  • Registered Users Posts: 1,256 ✭✭✭ JackieChang


    Kilboor wrote: »
    To be clear though, the S&P500 has an average yearly growth of 8%. Many websites sell this as the compounding factor, i.e. after year 2 the 8% gain will be on the principle + year 1s growth/return

    This.

    If I was invested in an S&P ETF I'd have to sell the gains regularly and buy back in to get this compounding factor according to my friend.

    I'm saying you shouldn't touch the unrealised gains so you can gain gains on your principle + gain.

    Let's forget that dividends even exist.

    The fact is my friend is saying unrealised gains are useless. He says they need to be cashed out, then you buy back into the ETF to see growth on your gains.


  • Registered Users Posts: 299 ✭✭ Live at Three


    This.

    If I was invested in an S&P ETF I'd have to sell the gains regularly and buy back in to get this compounding factor according to my friend.

    I'm saying you shouldn't touch the unrealised gains so you can gain gains on your principle + gain.

    Let's forget that dividends even exist.

    The fact is my friend is saying unrealised gains are useless. He says they need to be cashed out, then you buy back into the ETF to see growth on your gains.

    You're totally right. I could see your friend's point of view if it was about individual stock picking, timing, luck, reinvesting profits etc. but in the simple case you've described above none of that comes into play.


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  • Registered Users Posts: 8,751 ✭✭✭ Shedite27


    He said you need to sell your gains and buy back in, otherwise unrealised gains "don't mean sh!t" (his words)
    It's true that if you don't sell you really haven't made any money. My Fastly Shares went from $20 to $100 this year, on paper I'm $80 richer, but I didn't cash it in. It subsequently dropped to $80, so I've lost $20. That's what some people mean by "you don't make profit until you sell".
    I said leaving your unrealised gains untouched will add to the compounding effect.
    100% true, the more it grows, the more $ you get from a 1% increase in share price
    Then he said that the "unrealised gains is just a number on a screen and unrealized. If you want to earn money from your profit, you need to realise the profit and then reinvest it."
    Not sure why he thinks that, if you have $100 of Visa and it grows to $130, then it doesn't matter whether you sell and buy $130 Mastercard or stick with $130 of Visa, you still have $130 invested
    That doesn't make any sense whatsoever. So from now until I'm 95 years old I have to constantly sell my profit and buy back in? According to him, yes.
    He's wrong
    So I basically did a "Jimmy went to the shop" hypothetical scenario.

    Invest $100 in a stock that is guaranteed to go up 30% per year.

    Year 1: $130 (+ 30% of $100)
    Year 2: $169 (+30% of $130)
    Year 3: $219 (+30% of $169)
    etc. etc

    He said it doesn't work like that. You have to cash out your profit, and buy back in to get compounding returns. If you don't cash out, he said it will be:

    Year 1: $130 (+ 30% of $100)
    Year 2: $160 (+30% of $100)
    Year 3: $190 (+30% of $100)
    etc. etc

    The gains will only be on the original $100.
    He's wrong, balance will be $219
    The unrealised gains "only exist theoretically until you cash out and reinvest them" according to him.
    They are theoretic gains until you cash out (see Fastly example above), but cashing out and reinvesting doesn't change that. It's still the same type of gain (call it theoretic or real), until the day you cash it out and buy that Yacht


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