How do mutual funds/stocks earn compound interest?

I understand how compound interest works. I understand the concept as it applies to a regular bank account. Each month, interest payments are deposited into my account and next month, more interest is generated off the increased principal.

However, how does compound interest work in the stock market? If I make a one-time investment of $1000 in a stock and leave it alone for 5 years, the principal never grows. It stays at $1000. Unlike a bank account, the principal grows as I get paid interest monthly. Where's the compounding in a stock investment?

Thanks,
Andrew

If the stock doesn't pay dividends then it doesn't really compound, but what it does do is appreciate(grow in value). If it pays dividends and you reinvest the dividends that where compounding starts working. Reinvesting the dividends means that when it pays out a dividend, instead of taking the cash, you buy more shares with it.

But either way the rate of return is calculated as compound growth.

There is no compounding in stocks. There is only capital appreciation or loss and in some cases dividends. you are comparing apples & oranges.

As another poster stated, stocks do not compound earnings. You earn dividends if that stock pays any (not all do) and you will have a capital gain if the share price is higher when you sell it.

Mutual funds are groupings of securities (stocks, bonds, etc.) managed by a professional funds manager. The manager will buy and sell assets in accordance with fund objectives and his/her assessment of market conditions. Distributions to shareholders (dividends) are normally reinvested in more shares. Capital gains, if any, are declared annually.

They don't earn compound interest becuase they aren't interest bearing vehicles. Capital gains however can compound if the securities are held in a tax qualified account. This has nothing to do with whether or not the stock or fund pays dividends. If the account is a deductable IRA,SEP,401K,403B etc. the gains are taxed upon withdrawal, compounding until then. If a Roth IRA or 401K you never pay tax on the gains. :-) Otherwise you or the fund is taxed every year, re-invested dividends or not.

As for your stockmarket example; if you buy $1000 worth of a stock and five years later you have $1000 worth of stock you have done a poor job of stock picking. Let's suppose however that five years later your $1000 worth of stock is now worth $3000, not at all unrealistic I you know how to go about it. There's the compounding. When you sell, if the stock is not held in a qualified account you get dinged for capital gains tax if it is you don't. Hope this helps.

Well, I have to disagree with some of the previous posters. Yes, compounding occurs with dividends, but it also occurs with plain ol' growth.

If you have $10k worth of stock, and it goes up 20% in a given year, you've made $2000. If it goes up 20% again the next year, you won't make another $2000--rather, you'll make $2400, because you're now working with $12k in stock, not $10k. And if your stock continues to return 20% each year, your gain will continue to grow exponentially larger--even if you've never added any additional principal.

That, in addition to the dividend thing, is how compounding works with stocks.

Longarm is right.. your gains do not meet the actual definition of " compound interest" but similar gains every year would have a " compounding" effect.on your balance.
There are also some mutual funds that pay monthly dividends ( in the form of more shares) and there you can SEE the " compounding" effect in action...the fund's share price may only go up 7 cents a day...but because you keep getting more shares, your earnings are higher every time it gains.
I had one such fund( FNMIX) for years ( maybe $ 3000. original investment) and at first I would get 1 and a half shares per month...then two... four .. seven..finally after about I was getting 11 or so shares....I actually had more from dividends than my initial investment.... so...I sold off my $3000. worth...and put it in something else..BUT there is still over $ 3000. in FNMIX...just starting all over again...call it snowballing..or " compounding".