Compounding interest is the most powerful force in the world, according to Albert Einstein. If you’re an investor, you probably know about the snowball effect that if you push a small snowball down the hill, it becomes giant snow on the bottom.
Stock compounds the interest through accumulation and reinvestment of profits from price appreciation and dividends, over a period of time. For example, you invested $1 that is compounded at 20% per year, in five years your $1 would have grown to $2.49.
Basically, you earn interest from your outstanding balance plus accumulated interest income. In stocks, there are only two ways to earn: Price Growth and Dividends.
However, in the real world, there is no guarantee that you can apply compounding interest in stocks. You’ve got to find a reliable investing strategy to grow your wealth.
Without a method to extract money from the stock market, you could not compound your earnings. In addition, your strategy must produce consistent profits over time.
In this post, we will focus more on price appreciation and leave dividends alone. In case you want to learn what to do about it, you can still read below.
I have a short section to explain dividends in details.
Why do you think great investors always recommend going with stocks to grow your wealth?
Warren buffet has taught us about the snow ball effect, investing continually over time will lead to big profits.
Then again, how do you do that? You cannot buy any stocks without proper sets of rules.
Well, I am not going to show you how to do that in this post. You can always search this website for strategies. It can be technical or fundamental analysis.
Price’s appreciation is one way you can compound your earnings in stocks. For example, imagine you invested $10,000 in a security, and it grows 15% per year.
Using simple calculation the amount of profits you’ll receive is $1,500.
In the first year, your capital would now become $11,500. However, in the fifth year, your investment has doubled in value.
This is how compounding works in stocks. Moreover, as your capital grows, your earnings also increase.
That is why adding more to your capital creates the magic of compounding.
Even so, investing every month does not mean guaranteed profits.
You also have to look for trading strategies that proves to be effective.
How do you find a good system?
I would like to tell you my secret. Well, I do not trade if I have not tested the strategy.
That’s me, and I have been lucky because I started trading with the help of my mentor.
Most traders begin without someone teaching them, and they do not know what they are doing.
Who introduce you to trading?
My mentor is a Quantitative trader, and he taught me how to trade.
If a Quant is something new to you, go ahead and search how they build their trading systems. According to Investopedia, they use computer programs and algorithms to find trading opportunities.
Moreover, they test their strategies based on historical prices.
Usually, they use sample and out of sample data for back testing.
If you want to accumulate profits in the stock market, use a proven trading system.
You can read our recommended strategies for more details.
Accumulation of dividends is one way of compounding your earnings. The same with price appreciation, the earnings could increase the capital. Also, it can snow ball to larger profits.
Even so, not all companies pay dividends. They usually reinvest the income for more growth.
So, you cannot rely on dividends alone because a lot of times, the stock will go down after payment.
Instead, I recommend that you focus on the price.
There are two types of dividends: cash and stock.
The Cash dividends are actual cash paid to investors. However, some traders believe that an outward flow(this) of money could reduce the value of the stock.
If you take a look at history, why when a company pays cash dividends to shareholders, the price goes down?
The amount paid to shareholders has to reduce the company’s reserve and surplus. Not only, it shrinks the assets but also the perceive intrinsic value of the stock.
One method to take advantage of this opportunity is to select a good stock. Next, wait for a dividend declaration.
Then, watch the stock fall after the payment and buy the stock at cheaper price.
In contrast, stock dividend does not result to reduction of market value of a security.
When the management issues more shares, the price of the stock goes down. Furthermore, the stock looks cheap, and it may attract a lot of investors.
The price often shoots up after an issuance of a stock dividend because of the new adjusted price.
Combining Dividends and Price Growth
Now, we will talk about combining dividends and price appreciations.
The only rule is you have to reinvest everything you earned to apply the magic of compounding.
I know what you are thinking. You want to withdraw your profits because you want to buy a lot of things.
Am I right?
If you really want to compound your earnings in stocks, you’ve got to reinvest your earnings.
Furthermore, taking cash out will lower your chances of growing your wealth fast.
We have discussed above about the snowball effect. You earn more when your capital is bigger.
That’s why wealthy people have the ability to create more money.
It is not about how good your trading system, but how you speed up the creation of money.
You can only do that with compounding.
Of course, you need some money for expenses to motivate you, but take only around 2% of the total capital.
Overtime, that 2% could become huge, because you have compounded your money properly.
Patience is the key to successful investing.
While starting out, do not take a greater cut on your profits.
When you have a larger portfolio, you’ll realize that 2% of $5,000,000 can give you a decent living.
Of course, it depends upon where you are.
Focus more on growing your capital when trading stocks.
Do not think short term. If you want to be financially free, go for the long term.
You can’t use the magic of compounding in day trading because of high commission costs.
It can add up and could exceed your accumulated profits over time.
I hope you learned something today. If you have more questions, leave a comment below.
When I have time, I’ll do my best to answer it.
We have talked about price appreciation above. Now, let’s go to our investing strategy.
How do you ensure that the stock has growth potential?
Become a value investor. If you want to read about it, read my post about, “What fundamental analysis I use?”
I have laid down the rules on buying good stocks in there.
If you can’t find the search bar, you can use Google for it.
I know you want me to share it here, but this post is longer than expected.
Well, I’m already tired and I don’t want to keep writing the same thing over again.
However, I’m going to give you gimps of what I do.
Usually, I look for stocks with a little of premium in price. Buying at bargain is not a good idea.
Why do you think the price is lesser than the actual book value of the company?
The market could have discounted the company because there must be something wrong.
I also look at momentum. If the stock does not have it, I don’t buy it.
Avoiding stocks with no love from the market can save you from headaches in the future.
That’s it! I don’t have complicated strategies.
If you want to know more where I look for a trading system, please go to our recommended page above.
I know that investing in stock is complicated. However, it is also rewarding if you know what you are doing.
You probably heard Warren Buffet say, “Invest in America, and you’ll do well.”
He is not referring to his country only. As long as you invest in a handful of good stocks, you’ll be fine.
In essence, reinvest all your earnings in stocks to use the magic of compounding. Aim for growth in capital for higher returns.
Investing in good stocks could increase your returns. Of course, there is no guarantee that every stock you buy produce profits.
However, you could speed up the compounding of stocks by investing at regular periods.
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