The power of compounding returns can turn a modest level of investment into significant amounts of money if the compounding runs for a period of years. Some types of investments have implied compounding based on the growth in value. Others actually compound with the reinvestment of earnings. Understanding how your investments compound allows you to calculate projected future values of your investment portfolio.
Some types of investments provide their own compounding periods. These investments pay regular interest or dividends which can be reinvested. Income-paying investments include savings bonds, bond securities such as government, municipal or corporate bonds, and dividend-paying stocks. Mutual funds that hold these types of investments will also pay an income stream. Other investments grow through capital appreciation. The most common appreciation type of investment is shares of stock. The value change over time is a gain to your portfolio, but the profit is not realized unless you sell the shares.
Interest- or dividend-paying investments do not compound unless the income is reinvested. Bonds typically pay interest twice a year and many stocks pay dividends every quarter. If these earnings are not reinvested into more bonds or stocks, you will not get a compounding of the earnings. If you earn dividends every quarter but reinvest the dividends only once a year, the compounding period will be annual. Mutual funds provide the easiest path to compounding interest or dividends through the automatic reinvestment of distributions. Most stock mutual funds pay and reinvest dividends quarterly, and many bond funds pay monthly, allowing compounding on a shorter time frame.
General Rule of Thumb
For general financial planning and calculating future values of your portfolio or retirement accounts, using an annual time frame for compounding is sufficient. Most of the investments you use for long-term will provide historic returns on an annual basis. Each year you can forecast where you values should be at the end of the year and then compare the actual results when the year is finished. Even if investments compound at shorter time frames, most investment sources will discuss returns on an annual basis.
For investments with volatile values, calculating compound returns can be tricky. An example is stock or stock fund share prices, which may go up a lot one year and down the next. To calculate the compound return on these types of investment, you need a calculator or spreadsheet that calculates "internal rate of return." Also, past results for investments may not repeat in the future. Over a period of years you should track the yearly start and end values of your investment accounts and calculate your personal compounding rate.