How Does Compound Interest Work With An ETF?
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Question: In the second chapter of your book, Millionaire Teacher, you were explaining how compound interest works.
But is there any co-relation with investing in an ETF? I have the impression that we’re still highly dependent on the market price of the ETF, so it’s more like value investing that we foresee growth of this fund due to yearly yields. I can’t see any compounding effect in this case other than the reinvesting of the dividends part.
Answer: This is an excellent question.
Let me break the compounding down into two different elements.
The first part of my response may deviate a bit from what you are asking. But I just wanted to present a really thorough understanding before tackling the meat of your question.
- An ETF holds real businesses within it. Most of those businesses pay dividends. Each year, on aggregate, dividend payouts increase. That doesn’t mean the dividend yields increase. But the cash payout increases for each share held. The dividend yield is determined by dividing the price of the stock (or the ETF) by the dividends received. Let’s say a stock were valued at $10. If the dividend payout were 20 cents per share, we would have a dividend yield of 2%. Next year, that dividend payout could increase to 25 cents. Now imagine the stock price doubling to $20 per share. The dividend payout would still have increased to 25 cents, from 20 cents, but the posted dividend yield would now be lower, relative to the new price. The new dividend yield would be 1.25%.
However, when you keep adding the increasing cash payouts (of the increasing dividends) to buy more shares, those new shares throw off more dividends, which in turn can buy more shares. So there’s a compounding effect here.
- There’s also a compounding effect with the ETF’s price. It does not increase at a linear dollar level. As I explained in my book, Millionaire Teacher (2nd edition) on pages 90-100, a stock’s price (or an ETF’s price level) increases in proportion to the growth of the businesses that it holds within it. Long term, there is a one to one correlation. By long-term, I’m referring to periods of 15 years or longer.
Let me get to that “non-linear” growth component.
Let’s say you have an ETF that trades at $10 per unit. If it grew by 10% linearly per year, it would increase by $1 every year. After 21 years, it would be worth $31. But that’s not what happens with business growth. Business growth increases exponentially. It compounds. Like business growth, year-to-year growth of a stock or ETF’s price isn’t measured based on the year you first bought your ETF. It’s measured based on what level the ETF was at the previous year. That means, if this ETF grew in price at a compounding rate of 10% per year it wouldn’t have increased by $1 in its 21st year if it gained 10%. It would have increased by $6.72 in its 21st year. Over 21 years, the price of the ETF would have increased to about $74. I’ve used this price appreciation example without dividends, for the sake of simplicity.
You might be wondering then, why all stocks and ETFs are not priced in the thousands or tens of thousands of dollars.
For example, why is Coca Cola priced at $41.74 per share (as of this writing) instead of about $500,000 per share. The answer is that stocks (and ETFs) split their shares. They “look expensive” when they don’t split. So companies say, “Hey, let’s cut the price of the share in half and give everyone double the number of shares.” This happens every few years. It’s nothing more than a smoke and mirrors show. It doesn’t increase or decrease the value of anyone’s holdings.
Warren Buffett, for example, decided not to split his A class shares of Berkshire Hathaway. It doesn’t pay a dividend. You could have bought its shares for about $19 in 1965. As of this writing, they trade at just over $245,394 per share.
Let’s bring this back full circle.
Note below, how the shares increased by $542.50 the previous day. These shares initially cost $19 in 1965. But compounding internal business growth has ensured that, today, a 0.22% price increase in those original $19 shares means that the shares increased by $542.50 in a single day.