Saving for retirement - stocks and compound interest

[teejay]

This is a basic question I should probably know, but it struck me this morning while I was thinking about saving for retirement. Do stocks/mutual funds take advantage of compounding interest?

I'm 27 and started work about 1.5 years ago. For the past 6 months I've started adding to a 401(k). I am fortunate to make a nice income at a secure job so I can save close to the max each year, or around $15,000/yr. This also means Roths are not an option as I make too much to qualify. I've been investing in Vanguard 500 index and Total Market Index.

Whenever I calculate what I'll have for retirement I assume the interest compounds and, for example, assume I'll make 5% per year...(obviously I'd like to make more, but I assume a low number).

However, when you're investing in stocks/mutual funds is it really 5% per year? It's not like I realize that 5% at the end of each year (because I just hold the stock), and there's no guarantee the next year I'll make 5% on the 105% I own after year 1. This struck me and made me think I'm wasting a good opportunity, given my age and ability to save, to let interest compound. But I feel like I'm missing something. So what am I missing?

[Broken Arrow]

Do stocks/mutual funds take advantage of compounding interest?

It can! Assuming that it pays a dividend and it's being re-invested.

Otherwise, the main draw of stocks is its ability to rise in value (and fall).

Whenever I calculate what I'll have for retirement I assume the interest compounds and, for example, assume I'll make 5% per year...(obviously I'd like to make more, but I assume a low number).

Yeah, in practice, the stock market is a volatile place that constantly rises and falls. Unfortunately, there is no easy way to model and extrapolate that if we are doing long-term retirement planning. Hence the reason why we resort to a basic compound interest rate.

[jIM_Ohio]

Yes with stocks it might be more "compound returns" than compound interest.

Buy a stock today at $10 it might be $11 at year end.
The second year it might be $12.

So the stock price is growing at a compounded rate.

Add dividends into this and it works very similar to interest- just realize the stock price will NOT go up in a straight line.

[ksluis62]

Originally Posted by teejay

I've been investing in Vanguard 500 index and Total Market Index.

I think that's a good, safe strategy. The stock market historically outperforms other investments. Among stocks you own in these indexes will be the powerhouses of the future. Take a look at this article to see how company's like Cisco and Microsoft multiplied their stock prices 75 to 100 times over a period of a decade or so:

The Ten Best Tech Stocks Of All Time -- Seeking Alpha

Of course, you can't expect your personal returns to see the 75 to 100 multiplier. But these are the companies that pull up the overall stock averages so that you should realistically expect 10% or more compounded annual growth over the long haul.

You'll want to change your allocation to safer, less volatile investments as you get older, but stock indexes are a good, conservative investment at your age. You could consider more growth-oriented mutual funds if you want to be a little more aggressive, with more potential gain, but higher risk. With growth funds and stocks, you generally are not concerned with dividends. Its all about the appreciation in stock price.

[pgtr]

Originally Posted by teejay

This is a basic question I should probably know, but it struck me this morning while I was thinking about saving for retirement. Do stocks/mutual funds take advantage of compounding interest?

As mentioned above - essentially the same formula applies for calculating.

Originally Posted by teejay

I'm 27 and started work about 1.5 years ago. For the past 6 months I've started adding to a 401(k). I am fortunate to make a nice income at a secure job so I can save close to the max each year, or around $15,000/yr. This also means Roths are not an option as I make too much to qualify. I've been investing in Vanguard 500 index and Total Market Index.

Long before considering stocks as mentioned above I would recommend index mutual funds PRECISELY like the ones you've mentioned from Vanguard! I recommend maxing out your 401k as well as Roth IRA BEFORE considering additional investments (taxable) such as individual stocks. If you can invest in Vanguard index funds via your 401k - your fortunate.

Even after you max out for 401k and Roth contributions I would still recommend low cost index mutual funds over individual stocks etc.

Originally Posted by teejay

Whenever I calculate what I'll have for retirement I assume the interest compounds and, for example, assume I'll make 5% per year...(obviously I'd like to make more, but I assume a low number).

Yes you have to assume (guess) at an expected rate of return when making this calculation and it works pretty much as you're describing. 5% is a good conservative rate to put in for the long term. You also put in the number of years. And you need to put in what you'll be contributing each year. There's lots of online calculators and I bet Vanguard's website has them too.

Originally Posted by teejay

However, when you're investing in stocks/mutual funds is it really 5% per year? It's not like I realize that 5% at the end of each year (because I just hold the stock), and there's no guarantee the next year I'll make 5% on the 105% I own after year 1. This struck me and made me think I'm wasting a good opportunity, given my age and ability to save, to let interest compound. But I feel like I'm missing something. So what am I missing?

8% was a popular figure people used based but for estimating purposes 5% is fine too. These %s are all guesses as to future performance and within reason will work out OVER THE LONG RUN as in 10 or better yet 20+ years. If you are trying to calculator for just the immediate year - forget about it.

And it can all be affected by how Aggressive/Conservative you are in allocating your investments in your 401k etc.

[KTP]

Originally Posted by pgtr

Even after you max out for 401k and Roth contributions I would still recommend low cost index mutual funds over individual stocks etc.

Outside of a tax defered vehicle, like 401k or IRA, would you chose a S&P500 mutual fund over buying Spiders (symbol SPY). I guess the mutual fund might have a teeny bit lower expense ratio, but aren't the spiders going to be better for tax reasons? (I have heard the index mutual funds generate taxable transactions each year, where the only tax from holding the SPY shares would be tax on dividends, correct?)

Maybe I have misunderstood and the index mutual fund would actually not generate a taxable transaction until it is sold?

[blankcheck]

Originally Posted by KTP

Outside of a tax defered vehicle, like 401k or IRA, would you chose a S&P500 mutual fund over buying Spiders (symbol SPY). I guess the mutual fund might have a teeny bit lower expense ratio, but aren't the spiders going to be better for tax reasons? (I have heard the index mutual funds generate taxable transactions each year, where the only tax from holding the SPY shares would be tax on dividends, correct?)

Maybe I have misunderstood and the index mutual fund would actually not generate a taxable transaction until it is sold?

I agree, I've heard this as well, that if you want to reap the rewards of an index fund outside of a tax-deferred or tax-free vehicle, the best way to go is an ETF.