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.

  1. 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. 

  1. 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.

 

 

 

 

 


andrew hallam

andrew hallam

I’m a financial columnist for Canada’s national paper, The Globe and Mail, as well as for AssetBuilder, a financial service firm based in Texas. I’m also the author of Millionaire Teacher: The Nine Rules of Wealth You Should Have Learned in School (Wiley 2011) and The Global Expatriate’s Guide To Investing: From Millionaire Teacher to Millionaire Expat (Wiley 2015). My mission is to educate, motivate and inspire people on basic retirement planning and best practices for investing, using evidence-based strategies. I'm happy to comment on your questions. However, please read the Terms of Use.

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12 Responses

  1. Prabu says:

    Hi Andrew,

    Read your book and I enjoyed it very much. I’m now reading a few more including “A random walk down wall street” and “The Intelligent Investor”.

    I have a decent sized pot of money (AUD) I’ve saved up over the years and am now 33 years old. I’m thinking of placing it an index fund, such as Vanguards Growth Fund, which is a balanced fund.

    My questions for you:

    1) Is there any benefit in managing multiple index funds (US Stocks, International Stocks, US Bonds etc) and balancing them on my own, (while paying the fees for each one separately) over a pre-packaged balanced fund consisting of roughly the same diversity.

    I believe this you mention that you balance your index funds separately in your book. Although this might not be the case anymore.

    2) I’m from Sydney, Australia but currently live/work in the UK. I’m planning on returning to Sydney, but i’m not sure when. I’ll be in London for at least the next 12 months, potentially more. Further to that, I might move to the US after my stint in the UK.

    The way I see it I have a couple of choices:

    a) Open an index fund in Sydney, and dump my AUD money in there. Take a hit monthly or quarterly transferring my GBP to top up the fund. I think transferwise is best option here in terms of transfer fees.

    b) Move my AUD money to the UK and open a fund there, take a one time hit on the conversion, and add GPB at no cost. However, come retirement time, take a second hit bringing it back to Australia.

    c) Open two funds, top up the one where I’m living at the moment. Take a hit when I move.

    What are your thoughts on this?

    Cheers,
    Prabu

    • toony says:

      Prabu,
      Vanguard Growth fund is a great 1-fund portfolio, especially for those new to investing and/or too busy to manage/rebalance their portfolio.
      .
      Several advantages of a diy portfolio:
      1. Cheaper ER – Growth fund is 0.35% for $100k+ accounts. You can build 2/3/4 fund portfolio with ER 1/2 of that, ie. saving about $150-200 pa on fees with $100k portfolio.
      2. Asset allocation – Growth fund is fixed by fund management. Diy has ability to alter anytime/any reason, eg. increasing bond % as you age, add additional sectors or tilts.
      3. Fund choices – diy can mix any fund combination/providers you want
      .
      It’s best to place portfolio in currency of where you plan to retire/return to. I’m also Aus, earn in AED/USD and use Exchange4Free to send money home every month to invest in an AUD portfolio. For me, Exchange4Free has best rates/no fees (have tested many)! The margin is 0.01% from the live trading price! No fx conversion fees as send/receive from local banks).
      .
      Strive for simplicity – don’t try to juggle 2 accounts in different currencies etc. It will only give you a headache! 🙂

      • Prabu says:

        Thanks for the reply!

        What is ER stand for?

        I agree that being able to manage the balance of the asset allocation is a benefit. I figured that must be the primary reason to managing multiple funds.

        Although, the fee rate for an all in one fund is cheaper than the accumulated fee rates of several funds. At least with Vanguard I believe this is the case.

        I’ve decided to create the index funds in Aus, since I will be ending up back there eventually.

  2. Jen says:

    I wanted to post a new topic but could not see where to so am putting it on here.

    My experience as a lay person in the world of investing:

    Almost 2 yrs ago I woke up to to the fact that although my finances were sorted in my home country of South Africa; I was 46, an expat since 2001 and I might very likely not retire in SA! What could I do–the SA currency is not a strong one and I had no other investments elsewhere other than a 5 yr Generali policy (I cashed in immediatly I read Andrew’s web site).
    I ordered and read Andrew Hallum’s book and did three things: (two of which he does not recommend in his book)

    1-I opened an account with Saxo and started a ETF portfolio of 50% equities, 40% bonds, 5% gold and 5% property
    2-I started a unit trust (oeic) property UK
    3-I opened 2 small managed multi managed investment funds

    Most of my money went into the ETF portfolio and only small amounts into the other three. (monthly). I don’t know why I did this exactly but I sort of felt panicked–after all what if my low cost ETF portfolio did badly–there would be no one to blame,except myself! I felt the other investments were a ‘back up.’

    So here I sit in January 2017 two years later and looking at the results of the above three investments. I’ll share the results and my happiness level with you. (Bear in mind the way I have calculated the results is very simplistic: this is what I put in over the time period and if I took it out this is what I’d get. BTW 2015 was a horrible year for my ETF portfolio).

    1. ETF Portfolio total profit loss/profit over 22 months: +20,9% Super Happy (sure it might go down again but I have to stick it out)

    2. Property Unit Trust total loss/profit over 22 months: +10.5% Okay

    3. Multimanaged conservative fund over 16 months: +1.5% Super Unhappy
    Multimanaged growth fund(risky) over 16 months: +17% Happy

    So there you have it. From my lay experience and very unscientific experiment the ETF portfolio did the best!
    Don’t delay, try not to be too scared–as Nike says: Just do it!

    • Patrick says:

      This is great to hear Jen. I started with Saxo also about 6 months ago. Roughly I’ve seen about 200 GBP increase in the value of my account vs what I’ve put in, which isn’t that much yet and is also only 6 months. I certainly need to get out of the habit of checking it daily. I manage to put in roughly 1700 GBP every 3 months but will hopefully be able to increase this soon as it feels too little.

      Would you mind letting me know which was the best performing ETF and did you do any rebalancing (ie selling a % of the well performing ones to invest in the least performing ones)

      Cheers

      Patrick

      • Jen says:

        Hi Patrick-well my bonds have not done well (I have global bonds) and the global equities and the ftse 100 did well for me as did the gold and reit. I have not rebalanced as in sell one to buy another–I just always bought the lowest (which was bonds) and when I got sick of doing that and my bonds were getting above 40% I the bought the lowest equity I had (global or ftse). So on my Saxo platform I basically looked at the red figure and bought that or the lowest green one. I do check about every six months to see if it’s roughly balanced. I also used to check every day and toward the end of 2015 I hit a wobble as I basically made very little and posted a comment to Andrew that I was very very nervous and he said something like if I got nervous and stopped or took it out I,d become a statistic of those who lose….something like that anyway-it was in one of his articles on here.

        • Index says:

          Hi Jen,

          Which global bond ETFs are you using? I’m using IGLO (20%) and CORP (15%) – my allocation to bonds is 35%. I’m just interested to know which bond ETFs are being used by others and if there are any potentially better options out there for me.

          Cheers – Index

    • toony says:

      Jen,

      Congrats on getting out of the toxic Generali product – your future self is sending congrats to your current self 🙂
      .
      Was hoping the market would stay down in 2016 (and 2017 too) so I could buy the eft on sale (I’m still a little way from retirement)!
      .
      When markets go haywire, I simply remind myself to ‘stay the course’ as I have the cheapest, most diversify and efficient portfolio possible by using etf and guidance in Andrew’s book.
      .
      PS. It’s actually good to hear that your bonds is currently done (keep buying them according to your AA as they are on discount currently). There’s an important investment saying “if ALL your portfolio components are going up (or down) at the same time, you’re not properly diversified”! 😉

  3. Jen says:

    Mine is IAAA:Xlon it is in USD.

  4. Leesky says:

    Hi all . Brand newbie here just finished reading Andrews book and starting to look into investments and pensions. I have a ltd company consultancy so am looking at a Sipp (self invested pension) pension with Hargreaves and Lansdown because within that I can buy into various indexes including Vanguard. I’m in the Uk. Charges for the Sipp are not super cheap at o.45% but than massive advantage to me is that the pension contribution every month is a tax deductible expense and as a ‘pension’ is actually protected . I can trade and buy and sell within the pension without extra charges. Not sure if there are better options ?

    I have a somewhat stupid question. If I want to invest my money three ways and buy bonds, and maybe an international tracker and domestic index., and I not earning lower compound interest on 3 smaller investments than I would on one larger lump sum? I just can’t make it stack up

    Any advice is appreciated

    • toony says:

      Leesky,
      Whether you split your money into 1 fund or 3 funds (or 100 funds), you will earn the exact same compound interest 🙂
      .
      http://moneychimp.com/calculator/compound_interest_calculator.htm
      a) $3000 at 10% interest for 10 years -> $7781.23
      b) $1000 at 10% interest for 10 years -> $2593.74 (which is 1/3 of $7781.23)
      After 10 years, interest is same whether it was from 1 fund or 3 funds

      • Leesky says:

        Ah genius! Thanks so much
        It is all in the numbers after all. I could not get my head around it and presume I needed one big pot.