How often do mutual funds compound is a question that gets asked by many novice investors, who don’t completely understand the structure of this type of investment. A straight forward comparison of how compound interest works and the way the term may be applied might be the best way to understand the concept.
Compound interest is basically interest that continues being earned on an original sum of money invested along with the previous interest for a specified length of time.
For ease of explanation lets take 1000 dollars put into a bank account that is guaranteed to earn a 10% interest compounded semi annually. After 6 months you would have your preliminary amount plus 100 dollars, or a value of 1100 total. The second 6 months the bank will give you the 10% on 1100 which equals 110 for a total 1210 dollars at the end of the year. From this example it is easy to see that compound interest adds up quickly and the term compound is being used correctly in this scenario. The term compounding is used for specified periodic time frames.
Mutual funds are a some what different investment vehicle than a regular savings account. You still start out with purchasing an initial sum of money. This amount buys a number of shares in this organization. You own shares rather than just money. The management board of the fund are people, well versed in various methods to make money in just about any area you can imagine such as stock markets, currencies, commodities and many others. In short you are buying their expertise and pooling your money with many other investors.
The term compound is not exactly the correct way to evaluate how the fund is performing. You receive dividends based on their performance, which can be re-invested back into the fund giving you more shares. So instead of accumulating just money, you are accumulating even more shares. The more shares you own each time a dividend occurs the more new shares you receive and so on.
How often do mutual funds dividend, would be the correct way to express the question at hand. The share prices go up as they make money until management decides it should dividend. Dividends lower the cost of the shares again to a more reasonable level that new investors will feel comfortable buying. Keep in mind these management experts charge a fee for their worth, and usually there is a transaction charge either up front or when you sell your shares. This fee cost tends to make this type of dividend investing a longer term device.
All funds have a prospectus just like a stock and will give you the details of their track record over a number of years. The number of times it has performed a dividend cycle will depend on its management’s success in making money, it is not periodic like a bank account.
Your example is correct for a mutual fund paying 20% interest. If you wanted to correct it for a fun paying 10% interest it would only be $50 after six months.
The article actually says 10% compounded semi annually, not 10% annually, in which case you would be correct.