What you should know about your best friend…
Continuous compounding is often referred to as the Investor’s best friend.
And it’s true – compounding is probably the most valuable tool for any investor.
But today, I’d also like to tell you something you might not know about this “best friend” – he has a dark side.
He’s not exactly having an affair with your wife… but every now and then, he does take a slice off your profits.
Which is why I’d like to show you how you can enjoy the benefits of compounding whilst avoiding the pinch of his negative side…
Continuous compounding: getting onto the second half of the chessboard
First off, let’s look at compounding’s positive traits – and there are many.
There is an old story that goes something like this…
An old man presented the Chinese Emperor with a chessboard. The Emperor asked what he’d like in return for the gift, and the old man asked for one grain of rice on the first square, two grains on the second, four on the third, etc.
The Emperor readily agreed, little realizing that he’d be up to 8 million grains by the 24th square, and that there wasn’t enough rice in the world to cover the final squares.
In fact, the total weight of rice on the second half of the chessboard would be 460 billion tones – 6 times the combined weight of all the living things on the planet!
This is what compounding is all about – and if we think of profits instead of grains of rice, that’s how it can have a serious effect on your wealth.
In blunt terms, compounding is simply the process of reinvesting (rather than spending) your profits. There’s nothing complicated or clever about it – but doing this gives you the opportunity to turn your profits exponentially…
This is how compound investing profits increase compared to those on a simple, flat-staking plan:
Of course, time is a big factor in compounding, and it’s often talked about how much we can make by compounding over 5 years… 10 years… 20 years.
But as a trader, you’ve got an advantage: you’re just not compounding year-on-year – you can compound every trade.
Plus, as you can see on the chart below, a small difference in the percentage return on each trade can have a huge effect on how fast that wealth builds.
Rule of 72
There’s a quick and simple way to work out the maths behind compounding – it’s called the “rule of 72”.
All you need to do is divide 72 by the percentage profit you make on each trade to calculate how long it will take you to double your money.
Let’s say that you’re making 4% on each trade (remember, you’re probably only risking 2% of your fund on a trade, so that represents 2:1 profit ratio).
72 / 4 = 18
Which means that you could double your money in just 18 trades.
Now, that assumes that you’re going to win every trade, which I’m afraid isn’t going to happen.
Which brings me to the negative side of compounding…
What’s eating your profits?
Let’s say that you’ve got a strategy where each winning trade makes you 10% (I’m using big numbers here to make the maths a bit simpler), you’re risking 2% on each trade, and you’ve a win ratio of 50%. So, you’ll make 10%, lose 2%, make 10%, lose 2%, etc …. Therefore, your average profit on a trade is 8%.
According to our rule of 72, you should have doubled your money in just 9 trades (72/8).
Right?
Wrong.
Let’s see what happens if we start out with £100 …
1. win: £110.00
2. loss: £107.80
3. win: £118.58
4. loss: £116.21
5. win: £127.83
6. loss: £125.27
7. win: £137.80
8. loss: £135.05
9. win: £148.55
We’re doing pretty well, but we haven’t doubled our money.
When you’re compounding, just as your winning trades will significantly impact your returns – so too will your losing trades.
Another way to think of it is like this…
If you invested £1000 and in the first year you earned 20%, and then lost 20% the following year, and this up and down cycle continued for 20 years… How much would you have at the end? Your original stake?
The answer is a disappointing £664.83.
So, how do we avoid compounding eating into our profits?
How to stop compounding from pinching your profits
Rejecting compounding as a strategy isn’t the answer to this problem. To be a successful investor you must take advantage of compounding.
It is the single most powerful tool that you can apply to your investment fund.
But, to make it really work for you, you need to harness the power of another vital trading strategy …
… following the trend.
And … you need to have a few tricks up your sleeve.
To make compounding work, you must be on the right side of the market trend. Whether you’re a short-term trader or are holding long-term positions, you need to invest with the trend rather than against it.
And you’ll need all the tricks in your armoury – moving stop-loss levels up to breakeven, or using trailing stops in order to minimize losses or capture some profit from an investment. This approach can prevent losses from dragging on your compounded profits.
In my opinion, the combination of following market trends and compounding your profits are the two most significant ways to ensure successful investment. Add to that a little intelligent trade management – and you can start moving onto that second half of the chessboard…
In the next seven days …
In the UK, we’ve CPI and RPI figures coming out on Tuesday. The CPI figure last month came out at 4.5%, while the RPI, which includes housing costs and is (arguably) more in line with what consumers are actually paying out, stood at an eye-watering 5.2%.
Wednesday’s employment data will throw these numbers into stark relief, and there’s unlikely to be any movement on average earnings, which only moved by 2.3% in the year to April.
Retail sales numbers will be released on Thursday, amidst a lot of checks and balances against the effects of warmer weather and long weekends.
On the other side of the Atlantic, we have US retail sales figures on Tuesday, followed by CPI levels on Wednesday and building permits and manufacturing index on Thursday.
