Albert Einstein once famously said, “Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”
It isn’t’ relevant as much in any other industry as it is in trading and investing.
Compounding is when you earn returns on your returns. So, for example, if you started trading with $1000 and made a 5% return in your first trade, you now have $1050 to trade, which you again put in a trade to make another 5% profit. Now you have $1102.5.
Let’s look at another scenario. You start with the same $1000, make 5% on the first trade, but instead of trading with the entire $1050, you choose to use only your initial capital for your second trade, and leave your profits alone. When you make 5% in the next trade, your account total stands at $1100, which is $2.5 lesser than what you totalled while you were earning on your profits as well.
This $2.5 looks insignificant here, but it will add up to quite a lot when this exercise is repeated for 100, 500, or 1000 trades. Sample this, if you keep making 5% per trade for 100 trades and put your entire capital including profits on each trade, you will end up with an account total of $131,501, as opposed to $6,000 while trading only with your initial capital. That’s a huge additional $125,501 from compounding.
Here is a table elaborating on the “power of compounding”. Even at 1% compounding, the account growth increases multiple times that of the growth at a simple rate.
The Real World Trading
In the real world trading, calculations are never as simple as the ones in the above example. Trading isn’t profitable all the time. In fact, in the best of the times, the traders may be making millions, with a success ratio of only 50%.
That’s possible because these traders win big on the profitable trades and lose small on their losing trades. Whatever big profits they earn, they put them to use, essentially compounding their returns, and when they put some leverage in the mix, they further accentuate their profits.
Let’s look at the example in the last section again and add a little real-world twist - loss-making trades.
We assume that the trader earns 10% on each profitable trade, and loses 5% on each loss-making trade (A typical risk reward ratio). Let’s further assume that the outcome of each successive trade is the opposite of the outcome of the last trade. So, for example, if the first trade is profitable, the second in loss-making and third is again profitable and so on.
When repeated for 100 trades, this framework results in an account total of over $9000, when the profits are compounded, while it results in an account total of $3500 when returns are not compounded. Now, that is also a huge out performance of the compounding trading returns even when you have losses as regularly as you have profits.
However, the key is always to lose less and profit more. Einstein’s quote also says, “the ones who don’t understand the power of compound interest, pay it”. Therefore, when you lose more per trade than you profit, you will end up paying compound returns to the market and be compelled to throw the towel and leave.
The final word
Compounding is one of the most powerful concepts of finance and it means a lot for traders and investors alike. Therefore, it is extremely essential to get it right before you start trading.
While profit and loss is a function of many things including strategy and your general life conditions (stress), successful trading is almost always the function of right risk management. Compounding also works only when you are managing your risks the right way.
Most successful traders forget their actual initial capital and consider their total account value at any point (including profits) as their initial capital. This way, compounding works wonders for them, because they deprive themselves of the profit cushion that they have built. Hence, they always remain in the capital/profit protection mode, putting their profits to use and keeping their losses in check.
Therefore, before you start trading, you must get the compounding concept straight, so that you end up earning a compounded return instead of paying it.
You may also like our risk reward simulator here to look at the permutations of risk reward and strategy win rate - HERE