How to explain compounding to my wife.

[Oliver]

My wife asked me how the hold and keep mutual fund can be compounding. We have made a little money from NISA from our all country mutual funds. She wants to sell when we have made profit and buy again when it dips.
I actually don’t know how we are making profit. I
s it just that the yen is so low that we are just making profit because of the exchange. It is just beating inflation?
I am pretty clueless.
I just know I am not supposed to sell because……
someone clever please explain this to me as you would a 5 year old.
Thank you!
Also any links to YouTube explaining it would be great!

[TokyoWart]

You can think of compounding as just the series of increases in the fund's value each year. For instance, if a 1 million yen investment increased by 10% each year the first year's increase is 100,000 yen bringing you to 1,100,000 yen but the second year's increase is 110,000 yen because you are seeing the increase applied to the prior year's increase. The increases themselves are larger each year because they work on a larger basis. In the real world nothing increases by the same amount each year but in practice you do benefit from the way prior increases in the fund are themselves generating increases on top of what your original investment did.

I would also point out that compounding doesn't require reinvestment of dividends or interest payments and that is only a small part of the compounding that happens in mutual funds. You are seeing the compounding effect as the businesses behind each of the stocks in the fund become larger over time. When I graduated from college the A class of shares of Berkshire Hathaway were going for $3000 and they are now over $500,000 and have never paid a dividend over that time. That is all compounding.

Your wife's proposal to sell when the fund goes up and buy when it goes back down is just a proposal to time the market. I have never seen anyone do that successfully over the long term. There's no way to know when you are at a peak or trough and the tax friction for taking frequent gains lowers the effect of compounding.

[sutebayashi]

My wife asked me how the hold and keep mutual fund can be compounding.

Because of any dividends paid out by the underlying securities.

She wants to sell when we have made profit and buy again when it dips.

And leave the aforementioned dividends on the table, and also struggle to pick the time to buy back again.

This why the tsumitate approach works well over time. It automatically buys more on the dips, and less at the peaks.

I actually don’t know how we are making profit. I
s it just that the yen is so low that we are just making profit because of the exchange.

Probably true for this year.

In the end, “Time in the market beats timing the market.”

[Oliver]

Thank you for your rapid response!
I still don’t really understand how it is making money, so correct me if I am wrong, but I think that the mutual fund share is getting more valuable as the company grows bigger.
I think that is why I am making a profit.
All of the compounding is being done by the company reinvesting in itself, and the mutual fund reinvesting the dividend in the fund.
In any case don’t touch the money it’s working for me.
Is that right?

[zeroshiki]

Thank you for your rapid response!
I still don’t really understand how it is making money, so correct me if I am wrong, but I think that the mutual fund share is getting more valuable as the company grows bigger.
I think that is why I am making a profit.
All of the compounding is being done by the company reinvesting in itself, and the mutual fund reinvesting the dividend in the fund.
In any case don’t touch the money it’s working for me.
Is that right?

Basically, on the average, the world economy grows at a certain rate over time (we hope and believe). This is how the mutual funds get bigger. When you estimate they grow 5% per year on a 100 yen initial investment by you, after the second year, it's 5% of 105 since that's the current value of your money.

Its not true compounding in the sense of you putting your money in the bank and it earns interest on the principal but the effect is the same.

[goran]

I still don’t really understand how it is making money, so correct me if I am wrong, but I think that the mutual fund share is getting more valuable as the company grows bigger.

You buy fund A worth 100 JPY.
Fund A has underlying assets of Apple, Amazon, Alphabet and Adidas, in equal proportion.
So, you have 25 JPY worth ownership for each company.
Let's say in a given year, each company makes a profit of 20%, and decides to give 10% to stock owners. So you get 2.5JPY from each company via Fund A. And your fund is now worth 100 JPY + 10 JPY (2.5 JPY x 4 companies)

So, at the end of Year 1 your Fund A is worth 110 JPY, because the underlying companies decided to provide 10% as dividends, which was re-invested into the fund.
Next year, the basis for calculation will be 110JPY.

So, if same thing happens again, Fund A will be worth 110 + 11 = 121 JPY, at the end of Year 2.

I didn't understand any of this until last year, and this simplistic approach made it easier for me to visualize. Hope its the same for the OP.
If my understanding is incorrect, someone please correct me.

[Tkydon]

https://www.forbes.com/sites/alexknapp/ ... ial-curve/

https://en.wikipedia.org/wiki/Wheat_and ... rd_problem

[Oliver]

Thank you!
Why the tax book? Does this have something in their about NISA investing?

[Tkydon]

Thank you!
Why the tax book? Does this have something in their about NISA investing?

That's in my signature, because there are many people who ask tax questions.

[Oliver]

Gotcha, thank you!