The Power of Compounding

"The safe way to double your money is to fold it over once and put it in your pocket." - Frank Hubbard

I know that this is a subject that most of you understand but most of us tend to forget how powerful it is over the long run.  I spend a lot of my time chatting to investors about how to maximize their investment returns and it simply boils down to maintaining a consistent positive return year after year.

When I talk about consistent I am referring of course to small amounts of volatility.  Volatility is fine if you are trading but it can be murder on returns.  Selling at the lows and buying at the highs is the most common mistake made by pretty much all investors.  Eliminating this from your portfolio will produce far better returns.  If you could cut the losers from your portfolio and let the winners run I am sure you will agree that you would be in a far better financial position.

Now this is not easy to do for a number of reasons but the most prevalent reason of them all is that people get emotionally involved with their investments.  After months of research you buy into a position just as the market turns and you are instantly in a losing position.  You double down and it falls lower so you buy more.  Down it goes again.  Now your pride is hurt and you want to get even but the more you buy the lower it goes so the trade now turns to a long term hold.  There is no way that you will sell now that your pride has been called into question.  Rather sit on the position for eternity until it at least comes back to where you purchased it so that you can proudly tell everyone that you did not take a loss.

This is where you have thrown all thoughts of compounded annual rates of return out of the window.  The way to true wealth is through compounding but by dragging along a loser for years you have immediately dropped your total rate of return and thereby reduced the compounding effect on your overall portfolio.  Rather take the loss early and look to get in when the position is a lot lower or reinvest the proceeds into something that is working than have the drag on the portfolio.

Furthermore the psychological impact can be immense.  First off there is the negativity that can impact your social life and secondly it can have a negative impact on your next trade.  If the next trade does not go well then you can end up losing confidence and this can destroy a person's trading career.  I do not say this lightly as it has ended many a career on the trading floor.

As a brief recap on compounding, the table below shows you the impact that just 3 percent can have on a portfolio of $1 million:

Compound annual rate of return at 5% for 10 years = $1,283,359
Compound annual rate of return at 8% for 10 years = $1,489,846

The difference after 10 years is over $200,000.  This is not insignificant.  If you increase the time frame to 20 years the difference balloons to $2,214,162.  That is real money and therefore you should pay strict attention to all the investments in your portfolio to ensure that they are providing you a few extra percentage points of return as this can mean the difference between a happy retirement and one that is a struggle.

The last issue with this is that normally it takes a lot more risk to get those few percentage points than it is worth however one place that you can look is your cash deposits.  These create a huge drag on a portfolio as they are currently earning nothing.  Find a place that can provide you 2 or even 3 percent on this cash like fixed rate deposits and this will provide your entire portfolio the boost that it needs to get you to retirement sooner rather than never.