Repeatedly I see the term “compound interest” used to describe the growth of stock market investments. I think this is incorrect.
Strictly speaking, you only get interest from bank deposits and bonds. If you invest any interest you earn by depositing it in the bank or buying more bonds, then you earn interest on the interest — and that’s compounding.
If you invest in stocks, you (might) earn dividends. If those dividends are reinvested by using them to buy more stock, then you will start earning dividends on the dividends — and that’s compounding. But because there is no “interest” earned on stocks, I don’t think it’s right to call it “compound interest”.
Henceforth, I suggest we use “compound interest” only for investments in bank deposits and bonds … and we use “compound dividends” for investments in stocks. We can also use “compound earnings” in a general way to refer to any investments that grow as their earnings are reinvested in the same investment.
A little further explanation:
The interest you get from bank deposits and bonds arise from a contract: you deposit your money in the bank or you buy a bond (in both cases you are, in effect, lending money and the borrower is agreeing to pay you interest), and the bank or bond issuer is legally obligated to pay you the stated interest and return your money (the principal) to you.
The dividend you get from owning shares of stock is the portion of the profits to which you are entitled because by owning stock you become a partial owner of the company in which you purchased stock. However, dividends are not guaranteed as there might not be any profits or what profits there are might be used for something other than dividends, such as expansion or development of new products.
Learn more: … What are Stocks? Bonds? Mutual Funds? Index Funds?
