How is Money Made from Investing?

If you’re going to get serious about investing, it helps to actually understand where the returns come from. There are three main mechanisms that create value and build wealth through investing: capital appreciation, income (dividends and distributions), and compounding.

#1: Capital Appreciation

Capital appreciation is simply the price of a share, stock, or asset going up. If the price rises, the value of your investment rises by the same amount.

This can happen for a few reasons: the underlying company becomes more valuable through increased earnings or profits, demand for the stock increases, or positive news pushes the price up. For ETFs, capital appreciation happens because the basket of companies inside the ETF appreciates as a group.

Case Example

Steven invests $1,000 in a stock called CYN, valued at $1 a share. He now owns 1,000 shares.
Three months later, the price rises from $1 to $1.20. His investment is now worth $1.20 x 1,000 shares = $1,200.
He decides to sell. In three months, he’s made $200 in capital appreciation.

#2: Income (Dividends and Distributions)

Dividends are paid out from individual stocks. When a company earns a profit, it can either reinvest that profit to drive more growth, or reward shareholders by paying some of it out as a dividend. This can act as an incentive for investors, who go in expecting a payout on top of any capital growth.

Distributions are paid out from ETFs. When an ETF receives dividends from the hundreds of companies sitting inside it (say, from the ASX 200, the 200 largest companies in Australia), it combines all of that income together and pays it out to investors, usually quarterly.

#3: Compounding

“Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.”
This is where the real magic happens. Growth is slow at first, almost boring, but it accelerates the longer you leave it alone.

Case Example

Let’s run the numbers. If you invest $10,000 and it grows at 9% a year (roughly the historical return of the ASX 200 over the last decade):

  • Year 1: you make $900 (9% of $10,000), ending with $10,900
  • Year 2: you make $981 (9% of $10,900), ending with $11,881
  • Year 3: you make around $1,069 (9% of $11,881), ending with roughly $12,950
  • Year 10: you make around $2,100, ending with approximately $25,000
  • Year 30: you make around $11,000 in that year alone, ending with approximately $132,000

Notice what’s happening there. The dollar gains get bigger every year, without you putting in another cent. That’s compounding doing the heavy lifting.

This effect gets a further boost when your ETF offers a Dividend Reinvestment Plan (DRP). When an ETF pays a distribution, that money is automatically used to buy more units of the ETF. Those extra units then go on to pay you dividends too. You’re now earning dividends on your dividends.

Summary

There are a handful of mechanisms working together to grow the value of your investments, especially inside an ETF. If your ETF tracks the broad Australian market, it has historically returned around 9% per year, made up of roughly 4 to 5% capital appreciation and 3 to 5% dividends and distributions. Compound all of that together and it accelerates your portfolio over time, which is exactly why starting earlier gives you such an outsized advantage later.