{"id":90779,"date":"2023-02-01T09:34:00","date_gmt":"2023-02-01T13:34:00","guid":{"rendered":"https:\/\/www.shortform.com\/blog\/?p=90779"},"modified":"2025-09-15T10:16:27","modified_gmt":"2025-09-15T14:16:27","slug":"index-funds-compound-interest","status":"publish","type":"post","link":"https:\/\/www.shortform.com\/blog\/index-funds-compound-interest\/","title":{"rendered":"Compound Interest in the Stock Market: How It Works"},"content":{"rendered":"\n<p>What exactly is compound interest? Do index funds benefit from compounding?<\/p>\n\n\n\n<p>Compound interest is the interest earned on reinvested gains. Because interest compounds over time, your money grows exponentially instead of linearly. However, your losses also compound, which means that your actual return on investment might not match the market\u2019s average return.<\/p>\n\n\n\n<p>Here&#8217;s what you should know about the effect of compound interest. <\/p>\n\n\n\n<!--more-->\n\n\n\n<p><em>Editor\u2019s note: This article is part of\u00a0<a href=\"https:\/\/www.shortform.com\/blog\/hub\/personal-life\/health\/nutrition\/dieting-guide\/\" target=\"_blank\" rel=\"noreferrer noopener\">Shortform\u2019s guide to saving money<\/a>. If you like what you read here, there\u2019s plenty more to check out in the guide!<\/em><\/p>\n\n\n\n<h2 class=\"wp-block-heading\"><strong>The Power of Compound Interest<\/strong><\/h2>\n\n\n\n<p>Bogle notes that the small differences in returns between mutual funds and index funds yield outsized long-term results because <strong>interest compounds over time<\/strong>\u2014in other words, it grows exponentially instead of linearly.&nbsp;<\/p>\n\n\n\n<p>To see the effects of compound interest on index funds, imagine two funds: a mutual fund that earns 8% annually, and an index fund that earns 9% annually. If you initially invested $100,000 in each fund, they would deliver the following returns over time:<\/p>\n\n\n\n<ul class=\"wp-block-list\">\n<li>After one year, the mutual fund would return $108,000, while the index fund would return $109,000.<\/li>\n\n\n\n<li>After 10 years, the mutual fund would return $216,000, while the index fund would return $237,000.<\/li>\n\n\n\n<li>After 50 years, the mutual fund would return about $4.7 million, while the index fund would return over $7.4 million\u00a0<\/li>\n<\/ul>\n\n\n\n<p>So, while a 1% difference would only cost you $1,000 after the first year, it would cost you over $2.7 million after fifty years!<\/p>\n\n\n\n<h3 class=\"wp-block-heading\" id=\"h-the-reality-of-compound-interest-in-a-volatile-market\"><strong>The Reality of Compound Interest in a Volatile Market<\/strong><\/h3>\n\n\n\n<p>Although compound interest\u2019s impact is straightforward when annual returns are stable\u2014say, at 9% annually\u2014its effect is less straightforward when returns are volatile. The stock market, for example, is <a href=\"https:\/\/www.forbes.com\/advisor\/investing\/what-is-volatility\/\">notoriously volatile<\/a>. Stocks experience frequent price swings, and although the market increases <a href=\"https:\/\/www.nerdwallet.com\/article\/investing\/average-stock-market-return\">about 10% annually on average<\/a>, it also <a href=\"https:\/\/awealthofcommonsense.com\/2022\/01\/how-often-should-you-expect-a-stock-market-correction\/#:~:text=This%20means%2C%20on%20average%2C%20the,every%207%20years%20(20%25%2B)&amp;text=a%20crash%20once%20every%2012%20years%20(30%25%2B)\">drops 30% every 12 years<\/a>, on average.<br><br>To see how this bears on compound interest, imagine that you invest $1,000 in an S&amp;P 500 index fund for two years, and the market increases by 10% in the first year and drops 10% the second year. In this case, you would have $1,100 after one year, but only $990 after two years, because 90% of $1,100 is $990. So, although the average market return was 0%, you would have actually lost money.<br><br>In other words, your losses<em> <\/em>also compound when the market dips. In practice, this means that your actual return on investment might not match the market\u2019s average return. For instance, although the Dow Jones\u2014a prominent US stock index\u2014grew an average of 7.3% annually in the twentieth century, the compounding of market drops means that <a href=\"https:\/\/www.investopedia.com\/articles\/06\/compoundingdarkside.asp\">an investor in 1900 would\u2019ve only earned about 5% annually by 2000<\/a>.&nbsp;<br><br>To offset compounded losses in down markets, experts recommend various strategies, such as <a href=\"https:\/\/fortune.com\/recommends\/article\/how-to-invest-when-the-market-is-down\/\">purchasing bonds or emphasizing stocks that pay dividends<\/a>. These investments can provide financial protection even during bear markets (prolonged periods of declining stock prices).<\/p>\n","protected":false},"excerpt":{"rendered":"<p>What exactly is compound interest? Do index funds benefit from compounding? Compound interest is the interest earned on reinvested gains. Because interest compounds over time, your money grows exponentially instead of linearly. However, your losses also compound, which means that your actual return on investment might not match the market\u2019s average return. Here&#8217;s what you should know about the effect of compound interest.<\/p>\n","protected":false},"author":7,"featured_media":74859,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_jetpack_memberships_contains_paid_content":false,"footnotes":""},"categories":[31],"tags":[880],"class_list":["post-90779","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-money","tag-the-little-book-of-common-sense-investing","","tg-column-two"],"yoast_head":"<!-- This site is optimized with the Yoast SEO Premium plugin v24.3 (Yoast SEO v24.3) - https:\/\/yoast.com\/wordpress\/plugins\/seo\/ -->\n<title>Compound Interest in the Stock Market: How It Works - Shortform Books<\/title>\n<meta name=\"description\" content=\"Because interest compounds over time, index funds grow your money exponentially instead of linearly. However, your losses also compound.\" \/>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<link rel=\"canonical\" href=\"https:\/\/www.shortform.com\/blog\/index-funds-compound-interest\/\" \/>\n<meta property=\"og:locale\" content=\"en_US\" \/>\n<meta property=\"og:type\" content=\"article\" \/>\n<meta property=\"og:title\" content=\"Compound Interest in the Stock Market: How It Works\" \/>\n<meta property=\"og:description\" content=\"Because interest compounds over time, index funds grow your money exponentially instead of linearly. 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