Interest & Investing

[NetSkyBlue]

I apologize for the stupid question, I'm even reluctant to ask...but I realized I don't quite understand what interest has to do with investing.

I thought if I bought 50 shares of XYZ company at $1 per share now, and if I didn't add any more money, I would still only own 50 shares 30 years down the road. Hooray for me if the per-share price is $32 at that time, then I can sell my $50 investment for $1600. But where does interest come in to play? People talk about investments "growing", not just price per share increasing.

(I do understand that some stocks pay dividends, which can be used to purchase more shares, and that this is what is going on in my 401k, but that still isn't anything to do with interest.)

[Slug]

It's all dividend, no interest.

[kv968]

Like you said, dividends will buy you more shares of the stock. So in reality if you have the dividends reinvested, you won't have 50 shares in 30 years but maybe something like 70, 80 or more shares depending on the dividend yield and the price of the stock.

Dividends could be considered "interest" but I think what you're talking about is capital gains. Basically it's the fact that people are willing to pay more for the stock itself so the price goes up. The "growing" of a stock comes from dividends and capital gains.

[jpg7n16]

When most people talk about 'compound interest', 'interest rate' and 'rate of return' - they are talking about an increasing investment. The rate of growth of the investment can be measured, but obvioulsy not in inches, miles, or gallons.

So how do you measure the rate of increase? With interest rates.

The formula for calculating the interest rate is:
A=p*((1+i)^n)
"A" is the amount of your ending investment
"p" is the original amount of your investment (principal)
"i" is the interest rate per compounding period (aka growth rate)
and "n" is the number of compounding periods

Formulas like this allow you to compare investments in terms of the rate of return.


For example, imagine you invested $10,000 in a stock and 5 years later have $12,000. How did you do? Would you have done better with a 5 year CD paying 2.25%?

Your stock didn't pay any interest. It just grew in value. But the only measurement that makes sense is to convert that growth to a comparable "interest" rate.

A=p*((1+i)^n) becomes
$12,000=$10,000*((1+i)^5)
do some algebra, and...
i=(1.2^(1/5))-1=1.0371-1=0.0371=3.71%
i=3.71%

This fictional stock investment earned a compounded 3.71% which is better than the fictional 2.25% CD you could have invested in, therefore your stock was a better investment over this timeframe.


An interest rate for computational purposes is not necesarily what the IRS defines as "interest."

..................................

Oh and for your fictional purchase of 50 shares @ $1 growing to 50 shares @ $32:
A=p*((1+i)^n) becomes
1600=50*((1+i)^30)
do some algebra and...
i=32^(1/30)-1=1.1225-1=0.1225=12.25%
i=12.25%

So in your example, you would have made a compounded 12.25% for 30 years. Now you can compare your $50 stock investment to other investments available, by comparing "interest" rates.

[jteezie]

Interest rates play a huge part in stock valuation because the interest determines what people expect to earn on their investments. If interest is low, the company is more likely to borrow money (i.e. 0%) then turn it around into a project that earns a higher return (lets say 10%). This is how your stock price grows in real dollars.

The equation that shows this relationsip in respect to dividends is:

-------
Expected Price = D/( g - RFR)
D = dollar value of the dividend
g = expected % dollar growth of the dividend
RFR = risk free rate, the return if the company invested in the safest investment that has no downside risk, aka tbills usually.

g = ROE x dividend payout ratio
where ROE = return on equity, how effectively the company makes money with it's money (usually selling it's products and services, but sometimes also with investing activity).
dividend payout ratio = % of the company's profits (retained earnings) that it pays out as dividends.
-------

So you can see that stock prices will respond when expected growth of the company or interest rates change. Interest serves as a comparison that allows companies to decide what projects to invest in to make money, which ultimately effects the stock price.

[NetSkyBlue]

But the only measurement that makes sense is to convert that growth to a comparable "interest" rate.


Oh and for your fictional purchase of 50 shares @ $1 growing to 50 shares @ $32:
A=p*((1+i)^n) becomes
1600=50*((1+i)^30)
do some algebra and...
i=32^(1/30)-1=1.1225-1=0.1225=12.25%
i=12.25%

So in your example, you would have made a compounded 12.25% for 30 years. Now you can compare your $50 stock investment to other investments available, by comparing "interest" rates.

Thank you, that makes more sense. I always hear about investments and the beauty of compound interest, but I keep thinking, what if a stock price stays nearly the same for years, then all of a sudden shoots up? You're not increasing value as you would with compound interest, you're just benefiting from a massive stock price change.

Granted, most prices go up somewhat gradually, but this is the example I couldn't get my head around. In my example, one could say they made an average annual return of 12.25%, but in reality, for 29 years, they made a 0% annual return, and in one year, they made a 3100% annual return.

[jack11]

Recording accured interest on investments....answer posted in question can you help me understand how and why.?
4/1/12 bonds 11% due April 1, 2022, 100 bonds of $1,000 par each, intrest payable April 1 and October
7/1/12 bonds 12% due March 1, 2032 par $50,000 dated Mar 1, 2012 interest payable annualy on Mar 1

Above are the two bonds, the question is to prepare entries for the accured interest on Dec 31 2012. below are the answers. I understand the bonds amount, the percentages but do not understand the months accured.

12/31/12
Interest recieveable 7,750
investments 7,750

I see they did the 100,000 bonds times the 11% but why times the 3 months over the year? (100,000*.11*3/12)
Same for the 50,000 bonds times the 12% but why times the 10 months over the year?
(50,000*.12*10/12)

[yugugelizer]

3 months accrued, for the period October - December (Bond pays in April and October)

Although you purchased the bond in April, the interest earned from April - September is paid on October 1st, so no interest needs to be accrued at the end of the year.

10 months accrued for the period March - December (Bond pays interest in March)

Since this bond only pays interest annually in March, you need to accrue for the entire period you held the bond