Simple vs Compound Interest

How do simple and compound interest differ?

With simple interest, a depositor receiving annual interest removes the interest and just reinvests the principal, hence earns the annual interest rate. With compound interest, the depositor reinvests the principal and interest every year - the interest earns interest so the amount received goes up each year. Simple interest of 5% earned on $1,000 over 50 years equals $2,500, giving a total value of $3,500. With compounding, the total value at the end of the period is $11,467. The higher the interest rate the bigger the difference (albeit the same in percentage terms).

Apply the simple vs compound interest rate scenario to an investment

Investing $1,000 in equities, removing the annual dividend and earning the capital gain has the same effect from a returns perspective as earning simple interest. Reinvesting the annual dividend by buying more equity has the same effect as interest compounding. Assuming an annual capital gain of 10% and a dividend yield of 3.5% over 50 years but not reinvesting the dividend results in a portfolio value of $117,391 for a capital gain of $116,391 (final value minus the initial $1,000 investment) plus dividends of $40,737 giving a total gain in capital and dividends of $157,128. If dividends were reinvested, the capital value of the portfolio at the end of 50 years is $521,101. Reinvesting the dividend makes up a substantial part of the return.