I just learned about compound interest, and I want to know if I understood it right: You buy a stock, and then you just keep it. And over time, you will just earn interest on your interest. Is that correct? You have to do nothing else than to just buy a stock and wait. [...] really, all you have to do is just not take the gained interest out, right?
This is a more-or-less correct description of compound interest—except for the word “stock.” Stocks don’t usually1 offer interest, so buying a stock wouldn’t usually cause you to earn interest, compound or otherwise.
But if you bought into something that does offer interest—which could be as simple as putting money into a savings account, but many other options exist—this would be an accurate description. You would earn interest, and in most cases that interest would simply be put into the interest-earning account—where it will count towards future interest you might earn from that account.
E.g. 10% interest on $100 would net you $10—which means your account is now at $110 and your next 10% interest is $11 instead of $10. Note this doesn’t happen if the interest is taken out of the account (and in some cases, interest wouldn’t be able to join the rest of the account at all, so you would not experience compound interest at all).
Because in the videos I watched, compounding was explained as re-investing your interest, which implies that you have to take an action to re-invest it.
That’s usually correct: stocks don’t usually pay “interest” at all, but rather “dividends,” which is just money you get and you can do what you like with. If you go ahead and reinvest that money, then the result is rather like compound interest—the money you have already made is increasing the money you can make in the future. This isn’t automatic.
But dividends also aren’t primary way to earn money from a stock. The primary way in is by selling them later, after their value has gone up. The change in the stock’s value is automatic. In some ways (for instance, from the perspective of most tax authorities), you have automatically gained wealth if the value of stocks you own has gone up. This doesn’t really “compound” though, except in the abstract sense that the stock’s value has gone up because the company is stronger—and being a stronger company, might be in a better position to increase their value even more.
And ultimately, you would still have to choose when to sell the stock to realize the profit, so even though the value changes “automatically,” you won’t actually be able to use that wealth until you sell, and that’s not automatic at all (choosing when to sell and when to buy is immensely difficult). Once you’ve sold, assuming you made a profit, you now have more money—and again could funnel that back into new investments to hopefully “compound” your gains, in a manner of speaking.
Importantly, though, interest is usually guaranteed; if you buy into an interest-earning account, usually whoever took your money owes you that money as well as the agreed-upon interest, on the agreed-upon schedule. If they don’t provide it, you can sue them to get it.2 If they can’t provide it, usually these things are insured (legally must be insured) and so the insurance company will pay it to you instead—and again, if they didn’t, you could sue them to get it.2
Investing doesn’t work like that. When you invest, you are entitled only to get your slice of whatever money comes out of the investment, and nothing else. If no money comes out of the investment (company does poorly or whatever), you get nothing. If the company goes bankrupt, you not only get nothing, but also can’t sell your investment to anyone else because it will have no value. Investing always involves some risk. As other answers have suggested, diversifying is the tried-and-true way to mitigate those risks.
In order to receive compound interest, all I have to do is buy a stock once and then wait, and the compound interest will accumulate automatically, without me having to do anything for it. Is this correct? Thank you for your answer!
No, this is not correct—for stocks. It’s correct for things that actually earn interest, more or less, but not for stocks. For stocks, dividends have to be invested if you want to “compound” them, and moreover, stocks involve risk and so nothing with them is “automatic.” You might accumulate money—or you might lose it.
Say you invest 100$ into a stock, and it goes up 10%, so you made 10$, so now you have 110$. If you now just do nothing and just keep your stock that's worth 110$ and the stock goes up 10% again, you'll earn 11$. So now you have 121$ and you earned compound interest, and you didn't have to do anything for it.
You have to be careful here: up 10% from what? Percentages are always of something. Since interest payments are always made on a regular schedule in regular amounts, this is clear and we leave it out: each payment is made based on the amount in the account prior to the payment. But stock values fluctuate constantly: you have to arbitrarily choose some point as your reference, and then say its value is “up 10%” from that arbitrarily-chosen reference point.
If you say that the stock was worth $100 at point A, and at point B was up 10% from its point-A value, and then at point C was up 10% from its point-B value, then yes, your description is accurate. But points A, B, and C are all arbitrarily chosen: you could have chosen different ones and had different percentages. For example, suppose I said yesterday that it was up 10% from last month, and then said today that it was up 10% from last year: it’s entirely possible that the price hasn’t changed between the two days, if its price last month happened to be the same as the price last year. It hasn’t gone up 10% “twice.” And, for that matter, it could have lost money between yesterday and today—maybe yesterday it was up 15% over last year, but it took a big plunge and gave up a big chunk of value, and is now only up 10% from last year. You need to keep careful track of the reference points.
All that really matters, in terms of how much wealth you have, is the stock’s value today, not what its value used to be. (How it has changed over time can be important in deciding whether to buy or sell stock, of course.) This is very different from compound interest, where your 10% payment is $11 because of the previous $10 payment. With a stock, the value can (and almost-certainly will) go up one day and down another, and its past value is only indirectly relevant.
Always remember: past performance does not guarantee future results.
The word “usually” would need to appear in quite a lot of places in this answer; to make things easier to read and keep things more basic, I will be leaving most of them out.
Really, you “can sue” for pretty much anything. What I mean here is that you can sue, and have a reasonable expectation of success. You are legally owed that money and the court should back you up on that if necessary. Finding a lawyer to represent you wouldn’t be difficult and a court would take the matter seriously. On the other hand, if you couldn’t demonstrate any legal right to the money—for example, if this were an investment and not a guaranteed interest-earning account—, you’d probably not be able to find any lawyer to represent you and probably wouldn’t find any court willing to allow you to represent yourself. If you actually managed to get that far, you’d be laughed out of court—if not fined for wasting the court’s time.
