Last Updated on 3 November, 2022 by Samuelsson
Wealth creation is an art, and in trading, it is not achieved by earning a windfall profit from one trade. You can only accumulate wealth by skillfully handling your resources in a way that allows for growth over time, and one principle that captures consistent long-term growth is compounding.
Allegedly dubbed the 8th wonder of the world by Albert Einstein, compounding can help traders and investors multiply their returns over the long term when properly utilized, but whoever plays on the wrong side of it bears the pains of accumulated debts or depreciation due to inflation.
As a trader, you should never ignore the power of compounding. You can harness it to make your money work hard to earn more money for you. It does not matter how small the amount is, it can accumulate to a lot over a long time. But what exactly is compounding, and how can apply the concept in your trading?
What is compounding?
Compounding is the concept of continually reinvesting the earnings from an investment to generate more earnings, which are also reinvested to earn more, thereby growing the value of the investment over time. To put it differently, compounding is the process of generating earnings from both the initial capital and the earlier earnings on the capital.
The term compound interest refers to the sum of the accumulated earnings over the specified period. That is, the interest earned on the principal amount is reinvested, and it earns an additional interest — the accumulation of both the interest on the principal and the interest on the earlier interest is called compound interest.
So, compounding is basically a process of earning compound interest on an investment. Compounding is a simple concept but very powerful because it has a multiplier effect on the initial capital — the ability of the investment to generate earnings from not only the initial principal invested but also the subsequent interest earned over the coming period. No wonder Albert Einstein referred to it as the 8th wonder of the world: “The magic of compounding lies in the fact that it can help investors multiply their returns over the long-term”.
Compounding requires three things:
- The original investment remains invested
- The reinvestment of earnings
The more time you give your investments, the more your earnings would accumulate. So, to take full advantage of the power of compounding, you have to start investing early so that your investment will have enough time to accumulate and compound earnings. However, what you earn depends on the rate of returns, as that is what accelerates the income potential of your original investment.
To understand how compounding works, let’s take a look at this example. Assuming you invest $100 at a 10% return, you’ll have $110 at year’s end. If you don’t reinvest the 10 you earned, your return at the end of year 2 will still be just $10 (10% of the initial 100), and you will have only $120. But if you reinvest that $10 you earn the first year, you will also make a 10% return on it in year 2, so your total return on year 2 will be $11 instead of just another $10, and you will have $121 instead of $120 as you would if you weren’t compounding your earnings. See the two tables below for non-compounding investment and compounding one for a 10-year duration.
|Year||Return %||Accumulated Capital|
|Year||Return %||Accumulated Capital|
The graph below clearly shows the difference:
From the graph, you can see that while the size of the initial capital matters, reinvesting your earnings is how to grow wealth faster. Compounding the earnings has a snowball effect, making your investments grow faster. The most important thing is the marginal rate of return you get on the reinvested capital. But what do you think happens if you let that a $100 compound over many years? The two graphs below show how much the $100 would grow if compounded for 30 years and 50 years respectively at a 10% rate of return.
As you can see from the graph above, the $100 accumulates to almost $1,800 in 30 years.
From this graph, you can see that the 100 would have grown to $10,600 in 50. Note that the first 30 years made only 18 times the initial $100, while the last 20 years — from year 30 to year 50 years — made 88 times of that initial $100 and more than 5 times of the $1,800 made in the first 30 years. This explains why Warren Buffett is said to have made 99% of his wealth after he turned 50. That’s the snowball effect of compounding — no wonder the official biography of Buffett, written by Alice Schroeder, is titled “The Snowball”.
How to calculate the compounded value of an investment
While there are different formulas for different applications of compound interest, the basic formula for calculating how much a one-off compounded investment can grow over a specified duration and at a given rate of return is this:
A = P [1 + ( R / N )] ^ NT
A = the final amount
P = principal amount also known as your initial deposit
R = the annual interest rate, in decimal format
N = the number of compounding periods per year (for instance, monthly is 12 and weekly is 52)
T = the amount of time that your money compounds (in years)
For example, let’s assume you invest $1,000 in a REIT that earns 10% annualized returns, but it is compounded monthly. Here is how to calculate what your investment would amount in 15 years:
A = P (1 + [ R / N ]) ^ NT
P = $1,000
R = 10% = 0.1
N = 12 (monthly)
T = 15 years
Inputting the figures in the formula, you have
A = 1000 [1 + (0.1 / 12)] ^ (12 * 15)
A = 1000 (1.00833) ^ (180)
A = 1000 (4.454)
A = $4,454
So, by the 15th year, your initial investment would have grown to about $4,454. Subtracting the $1,000 initial investment, your gain would be $3,454.
Factors that affect compounding
As you can see, the two key variables in compounding are the time and rate of return. The other variable, the initial capital, is important but doesn’t have as much effect as the other two. Note that the number of compounding periods per year doesn’t add much difference. So, let’s take a look at Time and Rate Of Return.
The duration of the investment determines how long your initial capital and earnings can earn for you. It determines how long your earnings can accumulate. Every other thing being equal, the longer the duration the more the investment grows. So, someone who invested earlier would reap far more than someone who invested some years later.
For example, if Investor A and B put $1,000 each on a fixed-income security that offers 15% returns per annum. Let’s say that investor A invested at the age of 25, while investor B invested at the age of 35. By the time both turn 50, their investment would have grown to these:
For Investor A, the investment duration is 25 years (50 – 25), so the amount would be given as
A = $1,000 [1 + 0.15] ^ 25 = $32, 919
For Investor B, the investment duration is 15 years (50 – 35), so the amount would be given as
A = $1,000 [1 + 0.15] ^ 15 = $8, 137
As you can see, the sooner you start investing, the more time you will have to benefit from the power of compounding.
The rate of return
While the duration of the investment indicates how long the investment can keep accumulating earnings, the rate of returns determines how fast your investment grows. It is what determines the growth capacity of your compounded investment. Every other thing being equal, an investment that offers a higher rate of return would grow faster than the one that offers a lower rate of return. So, if the risk is not much, it’s preferable to invest where you will get a higher return per annum.
We should take an example to buttress this point. Let’s say Investor A invests $1,000 on a fixed-income security that offers 15% returns per annum and leaves it for 20 years. At the same time, Investor B invests the same $1,000 on a different investment that offers a return of 20% per annum and leaves it for 20 years. At the end of the 20 years, these are what they will get:
For Investor A,
A = $1,000 [1 + 0.15] ^ 20 = $16, 367
For Investor B,
A = $1,000 [1 + 0.2] ^ 20 = $38, 338
Notice that Investor B got more than twice what Investor A got in this example. Also, notice that, although this investment was for 20 years only, it grew bigger than the $32,919 Investor A in our previous example on time made in 25 years with an annual return rate of 15%. So, you can see that the rate of return has a higher effect on the investment than time.
Note that for most investments, the rate of return is not the same each year. An investment may return 10% in year 1 and return 20% in year 2. For such investments whose annual rate of return varies from year to year, financial experts use the term “compound annual growth rate (CAGR)” to indicate the mean rate of return over the duration of the investment. The CAGR is not an arithmetic mean, but rather, the geometric mean return from the beginning to the end result if the earnings were reinvested (compounding) at the end of each year of the investment’s life span.
How to use the power of compounding to grow your trading account
The same way the power of compounding is used to grow investments, you can use it to grow your trading account because your trading capital is an investment on its own. But since trading is an active process and with no consistent rate of returns, you need to know how to actively make compounding work for you.
Before we go into details, let’s examine some important trading concepts you should know, which are necessary for implementing a growth plan. These are the three key ones:
- Account risk percent: This refers to the percentage of your trading account you risk per trade. This can be 1%, 2%, 5%, or even 10% if you are an aggressive trader. Most experts advise traders to risk only 1% or 2% of their account capital in each trade to reduce the possibility of blowing their accounts in no time. Once you have chosen the right percentage to risk in each trade, you may want to keep it constant.
- Position size: This is the quantity of the instrument you carry in each trade. For stocks, it is the number of shares you buy, while for futures, it is the number of contracts you want to trade. In forex trading, it is called lot size. Whichever the market, your position size is a function of how much you want to risk in that trade. To get your position size, you need to convert your account risk percent to the dollar amount. For example, if you have a $10,000 account and decides to risk only 1% of it in each trade, it would translate to risking only $100 in each trade. With this, you can calculate your position size if you have decided where to place your stop-loss order. Here’s the formula in the case of stock trading: Position size = account risk (in dollars)/ (stop lose size x the share price). Assuming the account risk is $100, the share price is $5 per share, and the stop loss is 10%, the position size (number shares to buy) is 200 shares (100/[5×0.1]). Thus, as your account balance grows, your position size increases without increasing your account risk percent.
- Reward/risk: This is the ratio of what you stand to make for any risk you take. It depends on your trading strategy. You can have a trading strategy that allows you to have your profit target at 2 times your stop loss size. For instance, if your stop loss is a 10% drop in share price, your profit target can be a 20% gain in the share price. So, if your strategy has a fixed stop loss and profit target, you can only increase your earning by increasing your position size, which you can do only when your account balance increases so that you don’t increase your account risk percent.
Now, let’s see how you can compound your earnings and grow your account size faster. We assume that you are starting with a $10,000 account and plan to only risk 1% of your account per trade. So, in your first trade, you risked $100 and bought 200 shares of a stock trading at $5 per share (we ignore commissions to make things easy). Let’s say that your reward is twice what you risk and the first trade is a winner, your account balance would grow to $10,200 after the first trade.
For your next trade, risking the same 1% of your account balance, you can now trade with $102 (10200/100) in a trade. So, your previous $200 profit is now being reinvested (of course, at your usual 1% risk rule), as it contributes $2 to what you can trade in this next trade. Assuming you want to trade another stock that is currently trading at $5 per share (our first stock is likely trading at $6 per share and probably shows no trade setup), you get your position size as usual: 102/(5×0.1) = 204 shares. You can now see how your previous profit is contributing to increasing your position size. With your usual reward/risk ratio, if this trade is also a winner, you gain $204 for risking $102. So, your account balance increases to $10,404, instead of just $10,400 if you hadn’t reinvested the previous profit.
However, trading is not all about winning; there would also be some losses. Assuming your second trade ended in a loss, your account would be down to $10,098 (after losing the $102 risked). You can risk $100.98 (approximated to $101) in the next trade and still have part of your initial profit working hard for you.
By and large, if you have a strategy with positive expectancy (say a 50% win rate and 2:1 reward/risk ratio) and you risk only 1% of your account balance per trade, you can always grow your account while compounding your earnings in the process.
How the power of compounding can negatively affect your trading
The power of compounding can negatively affect your trading if you’re on the wrong side of it. The fact is that you pay for compounding whenever you take an interest-yielding loan because the interest will keep compounding the amount you’re owing as time passes.
In the trading and investing world, you get on the wrong side of compounding when you trade with borrowed funds. This can happen in either of these situations:
When trading stock on a margin account, your broker lends you some of the funds you are using to trade. Of course, the loan comes with an interest. So, your trade must be making enough to cover the interest and make some profits.
If your trades are not making enough profit to cover the interest, you will be losing money, and depending on the duration of the trade and the compounding period of the interest, your losses can easily increase. Worst of all, if your trade is in a loss, the compounding interest can easily worsen your losses.
Credit card cash advance
Most brokers don’t accept depositing with a credit card because they don’t want you to trade with borrowed funds, knowing that trading is risky and you can always lose your capital. However some still allow it, and some traders even take a cash advance and then deposit the cash with the broker. Whichever way, using your credit card to fund your trading account is very risky.
If you are not making enough money to cover the interest on the credit, you will be losing because the interest compounds over time.
What to learn from compounding
There are many things we can learn from the concept of compounding. These are some of them:
1. Starting your investment journey early
One of the key factors in the compounding formula is time. So, the early you start investing, the more money you will have by retirement. In fact, if you invest a huge amount early enough and are getting high returns from it, you might even retire earlier than you imagine.
2. Having a long-term outlook in trading
It is very important to have a long-term outlook in trading. Even with the best strategies, earnings will take time to compound to huge amounts. Be patient with your trading journey!
3. The smallest rate differential matters over time
In investing, if you have two investment options, go for the one that offers a higher rate of return, even if the difference is very small. The difference will have a huge impact over time due to the effect of compounding. The only reason not to go for the higher return is if it carries too much risk.
4. Time value of money
The value of fiat money reduces with time, often due to inflation. Unfortunately, this depreciation can negatively compound with time. This is why when investing, you have to be sure that the return on the investment is higher than the inflation rate; if not, your investments would still be losing value.
5. Pay up your debts in time
The longer your debts linger, the more the interest compounds. It would get to a time the initial capital would be just a fraction of what you pay interest.