Compounding can be used to great effect in your day-to-day trading. I’ve had a number of people ask how to use compounding to improve investment returns, so today we will discuss this in more detail.
The Greatest Mathematical Discovery Ever Made
Albert Einstein once remarked that the most powerful force in the universe is compound interest. He came up with a formula called the Rule of 72. It states that if you take 72 and divide it by the annual percentage return, it will give you the number of years it would take for your investment to double.
For example, say you invested $100 into a stock that gave you an annual return of 20%. At the end of one year, you would have $120. Instead of taking out the $20 profit, you leave it inside for another year at the same 20%. At the end of the second year, your investment would grow to $144. The next year, it would grow to $172.80 and on the fourth year, it would grow to $207.36.
Using the Rule of 72 you can quickly do the maths. In this example, if you calculate 72 divided by 20 you get 3.6 – ie. in 3.6 years your investment of $100 will have doubled.
Warren Buffett
Compounding is one of the wonders of the world and Warren Buffet has used it to great effect in getting the value of his investments to grow at spectacular rates. He has heralded compounding as his “secret weapon” in creating the second biggest fortune in the world, purely by investing in US stocks.
Warren Buffett achieved an average annual return of 24.7% for 49 years! This means that his money doubled every 2.9 years (72 / 24.7). He turned an investment of $100,000 in 1956 into $4,200,000,000 ($4.2 billion) today.
To put it simply over longer time frames, the impact of compounding becomes dramatic.
Compounding and Retained Earnings – Warren Buffett
Warren Buffett has referred to the use by a company of its retained earnings as a test of company management. He says that if a company can earn more money on retained earnings than the shareholder can, the shareholder is better off (taxation aside), if the company retains profits and does not pay them out in dividends. If the shareholder can achieve a higher rate of return than the company, the shareholder would be better off if the company paid out all its profits in dividends (taxation situation again excluded) so that they could use the money themselves.
In summary, if a company can retain earnings to grow shareholder wealth at better than the market rates available to shareholders, it should do so. If it cannot, it should pay the earnings to shareholders and let them do with them what they wish.
In the book “The Snowball – Warren Buffett and the Business of Life“, there are some great revelations including realising the power of compounding. Compounding is like a snowflake that rolls into a snowball with time. $10,000 invested at 7% is worth over $20,000 in 10 years’ time. In 50 years’ time, that $10,000 is worth more than $300,000. Of course, this does not take into account inflation eating away at your capital, but with many stocks offering a 7% yield the capital growth could mitigate the effect of inflation and in fact beat it.
Applying Compounding in Day-to-Day Trading
The average investor can follow the path of the investing icons like Warren Buffet, if they have the time and the patience to implement his methodology. There are a couple of additional rules that Warren Buffet adheres to in investing: “Rule 1 – Do not lose money, and Rule 2 – Do not forget Rule 1″.
Active Investors and Compound Returns
Active investors can apply the same compounding philosophy into their trading plan, through the utilisation of compound returns. Compound returns are achieved when you invest a sum of money at a particular rate of return. Instead of removing the monies that you have accumulated from the investment, you add it back to the principal sum and reinvest this larger sum. So the next time, the rate of return is on a larger principal sum. This continues until the returns become greater and greater!
Compound return is return that is paid/earned on both the principal and also on any accumulated monies from past years. It is often used when someone reinvests any interest/earnings they gained back into the original investment. Over time, compound returns will make much more money than simple returns because the interest is earned on larger and larger amounts.
The formula used to calculate compound return is:
M = P(1 + i)^N
M is the final amount including the principal.
P is the principal amount.
i is the rate of return per year.
N is the number of years invested.
Let’s say you had $10,000 to invest for 3 years at rate of 5% compound interest. Using the above formula your $10,000 would be worth $11,576 after 3 years. Using a Microsoft Excel spreadsheet you could simply enter “=10,000*1.05^3”, and Excel will return the answer.
Practical Application of Compounding Returns
We have done some analysis of how you can use compounding returns to improve your trading performance. Active traders can use this in their Trading Plan, to increase their capital invested by reinvesting their winnings.
In the chart below we have started with a $10,000 initial investment and calculated possible returns at varying investment returns. We have calculated the returns weekly with investment returns of between 2% and 10% per week. These returns would be your net returns (after any costs). For example if we had a $10,000 initial investment and reinvested monies earned at 2% per week, after 10 weeks you would have $12,190 to invest. If your investment return improved to 4% per week after 10 weeks you would have $14,802 to invest. After 20 weeks of consistently earning 2% and 4% per week you would have $14,859 and $21,911 respectively.
From the chart you can see the returns are magnified if you can consistently grow your investments at a steady rate of return.
Returns generated on an initial investment of $10,000 compounding weekly on various rates of returns. Note the lognormal chart axis.
The secret is consistency, time and the power of compounding! I have also supplied the table used for this chart for your reference.
Keys To Success
• For compounding to work you need to generate consistent returns.
• Be realistic about your goals for investment returns.
• Requires a systematic approach to your trading.
• We have used 30 weeks in the chart example provided because there will be weeks when your trading produces a loss.
• There are 222 trading days for the year, which equates to 44.4 trading weeks. So you can improve your results if your are consistently profitable.
• Manage your losses and keep them small! We will discuss how to accomplish this in later articles.
Conclusion
The power of compounding is one of the greatest wonders of the world. It works especially well for wealth generation, and investing icons like Warren Buffett have used it to dramatic effect on the growth rate of portfolio returns.
The example given in this article clearly highlights the magic that the process of compounding works on one’s trading. By generating consistent returns and letting your money compound over time, you have the potential to improve your returns.
Investment returns over a long period are not so much dependant on the amount of money you have to invest, but rather they are more a function of letting compounding work its magic by starting to invest as early as possible.
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Michael Hevern
Investment Adviser – D2MX Advisory
TABLE: Returns generated on an initial investment of $10,000 compounding weekly on various rates of returns.
Also in This Series:
>> Simple Trend Finder Scanning Method: Part 1 Stock Trading Tips for All Types of Market Environments
>> Going For Gold: Part 2 – Stock Trading Tips for All Types of Market Environments
>> The Gap Trading Method: Part 3 of Stock Trading Tips for All Types of Market Environments
This report was prepared by Michael Hevern. It represents the views and opinions of the author. It is not intended for use by any third party, without the approval of Michael Hevern. While this report is based on information from sources which are considered reliable, its accuracy and completeness cannot be guaranteed. Any opinions expressed reflect my judgment at this date and are subject to change. Contracting Hevern Pty Ltd is a Corporate Authorised Representative No. 408868 of D2MX Pty Limited ABN 98 113 959 596, AFSL No. 297950 (D2MX), and Michael Hevern has been appointed as an Authorised Representative of Contracting Hevern Pty Ltd. Opinions, conclusions and other information expressed in this report are not given or endorsed by D2MX, unless otherwise indicated. The information contained in this Report is General Advice only, as the information or advice given does not take into account your particular objectives, financial situation or needs.
Disclaimer: Using leverage to invest can be a two edged sword, as it can magnify your returns when the stock price rises, but will in turn magnify the losses if the trade does not perform as expected.
