Compound investing – the shocking truth about the negative effects it’s having on your money

Compound investing is touted as the best way to make long-term wealth – it’s the poster-child of the investment world … and, the truth is, that it’s just not possible to make serious money from the markets without relying on compounding.

But don’t be fooled …

Nothing is 100% benign.

There’s a side to compound investing that can COST you money, if you’re not careful.

But before I go on … I must make one thing clear …

I’m not suggesting that you don’t use compound investing. But it’s important that you understand how it works, so you can select the BEST way to apply it to your trading.

Compound investing is the single most powerful tool you can unleash on your fund

When he died, Benjamin Franklin, a man renowned for his money-management, left behind him a plan to enrich the cities of Boston and Philadelphia.

He left around $5,000 dollars in a fund to each city, under the conditions that this money could be loaned to needy borrowers at the rate of 5% annually. The fund should remain untouched for 100 years, at which point the city could spend ¾ of it on a city improvement project, and the rest was to be kept for another 100 years.

Franklin estimated that, with an annual return of 5%, after the first 100 years, each city would have around half a million dollars of spending money. And after the full 200 years, they would each have over $21million.

Franklin had a good deal of faith in the power of compound investment.

What his plan failed to take into account was volatility

Both cities struggled to achieve a reliable 5% return each year – there were tough times during those 200 years, and plenty of bad debts and mismanagement. So, after two centuries, the Boston fund stood at $5,533.316, and the Philadelphia one contained $2,497,933.

Compound investing is very vulnerable to volatility in the market … if you can achieve a steady return, it’ll work exactly as advertised … but if your returns are good one year, poor the next, then compounding can go awry.

Take a look at this example …

Let’s say that we have £100 to invest, and we expect to make 20% profits on a good year, and 18% losses on a bad year. And we get 50% good years, 50% bad years. It’s not a big margin, but if you’re making more than you’re losing, you should expect to come out on top … right?

Here’s how the first ten years might go …

£120

£98.40

£118.08

£96.83

£116.19

£95.28

£114.33

£93.75

£112.50

£92.25

Your average annual return is +2%, but because of the volatility of the 20% upswings and 18% downswings, this is being eaten away by compound investing.

Compare this to how you’d fare with a 2% steady return over the same 10-year period …

£102

£104.04

£106.12

£108.24

£110.41

£112.62

£114.87

£117.17

£119.51

£121.90

I don’t say this to put you off compounding, but to make us consider HOW we compound, and WHEN we compound.

When to compound

If you have a bank account that pays out interest on a daily basis, you’ll make more money than if the same annual rate is paid out once a year.

Likewise, if you compound your winnings after each trade, you can make more money than if you sit on your winnings, keeping your stakes steady, only increasing those stakes once you’ve added up your winnings at the end of the year.

However, as we’ve seen above, there’s a difference between a bank account that pays a steady return, and trading, which by its nature gives us more volatile returns – there will be good periods, and bad.

By choosing to switch our compounding to a longer timeframe, we can help to smooth out some of this volatility. So, don’t assume that it’ll always be best to compound as often as possible – look at your results, and use your staking levels to help smooth out your returns.

Other staking plans

Other ways to reduce the volatility of ups and downs include only reinvesting a proportion of your winnings.

Come the end of the month, if you’ve made a profit, you could reinvest half of that profit, and hold back the other half to dip into should you experience a losing month.

Again, this can have a smoothing effect on your returns.

Another method to reduce the effects of volatility is to increase your stakes when your fund grows, but to not decrease them when your fund size reduces …

Looking at the example I used above (with 20% gains and 18% losses) this would work out …

£120.00

£98.40

£122.40

£100.37

£124.85

£102.38

£127.35

£104.48

£129.95

£106.56

That seems to have solved the problem … but it ignores the other important fact about trading – our winners and losers don’t come evenly spaced. Instead, they have a habit of bunching up, and a losing run could quickly decimate this account, unless you’re employing another back-up plan (like putting aside previous profits).

Managing volatility

The big lesson to learn here is how important it is to NOT LOSE MONEY.

Serious traders know how important a good success rate is, and will happily close out trades for small wins or even at breakeven to avoid taking losses. Trading is all about volatility – it’s how we can make superior returns, rather than sticking our money in the bank.

But it’s also about managing that volatility. And small, regular profits will beat wild ups and downs over the long term.