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LISTEN TO THIS ARTICLE:Compounding refers to the use of market returns to increase gains exponentially. Simply put, the profit earned over a given period is added to the initial investment, and then the entire amount is reinvested. This way, the profit-earning process is accelerated as the wealth grows exponentially.
The idea behind compounding is to let money work for you. In other words, letting money accumulate at a compound interest rate over a long period of time leads to accumulated wealth.
Financial markets are all about yields or potential returns. The yield, or the interest, is what attracts investors to 1 financial asset or another. When central banks raise the interest rate level, commercial banks pay higher interest on deposits. Central banks tighten monetary policy because investors are attracted by the higher interest rate paid on deposits.
On the other hand, when central banks cut interest rates, they are trying to stimulate economic activity. Commercial banks will cut their rates, too, trying to make businesses and households look for a higher yield elsewhere. In the case of households, the stock market is attractive in a low-interest-rate environment. In the case of businesses, they will take higher risks and invest their capital in the search for a higher yield. A higher yield is key to compounding. Everyone wants to compound their money at the highest interest rate possible.
This article aims to present the numbers behind different compounding strategies to help traders and investors with their money management strategies. Money and risk management are the foundation of successful trading and investing, and both traders and investors want to compound their earnings at the highest interest rate possible.
How to Compound Earnings
We should use an example here to illustrate the concept of compounding better. Let’s say that you have $1,000 to invest for 1 year at an interest rate of 5%. At the end of the period, your account will have the original investment, which is $1,000, as well as an extra $50, which represents the interest for the year, calculated as $1,000 * 0.05.
Now, let’s assume that you want to invest the original amount for a more extended period, say 2 years. This is called annual compounding, and on top of the interest you received on the original amount, you will receive so-called “interest on interest.”
If we continue with the above example, the interest corresponding to the 2nd year on the original investment remains the same, namely $50. However, the total amount earned also contains interest for the 2nd year based on interest earned in the first year. More precisely, $50 is the interest earned in the 2nd year, and the interest on interest is $50 * 0.05 = $2.5. In total, investing $1,000 for 2 years with annual compounding at an interest rate of 5% returns $1,102.5, or $102.5 more when compared to the start of the period.
The $2.5, which represents the interest earned on interest, is what investors know as “compounding.” So why is it so special?
It is special because, unlike the interest earned on the original investment, which is fixed over the investing period, the interest earned on interest grows in size each period. We can, therefore, say that the importance of compounding grows with the growth in the interest rate used for compounding. In other words, the same amount compounded over the same investing period will yield more significant returns if we use a higher interest rate. Thus, the concept of annual compounding is useful when discussing the dividend payments that shareholders receive.
Reinvesting the Dividends
Many publicly listed companies (but not all) choose to reward their shareholders by paying a dividend. Investors who own shares in a company have the right to receive dividends and participate in management decisions.
A dividend is a share of a company’s profits that is distributed to shareholders. It is a way for a company to reward shareholders for their trust, and the dividend policy is an important tool that a company’s management uses to attract investors. Dividends can be paid annually (e.g., in Europe, most companies pay an annual dividend) or quarterly (e.g., in the United States, dividends are paid quarterly).
In the notion of compounding explained earlier, a dividend may be viewed as the “interest” earned on one’s original investment. For example, if a company pays a dividend of $1 per share and an investor owns 100 shares, the dividend amounts to $100.
Reinvesting a dividend is just like earning interest on interest. By reinvesting the dividend, the investor uses the proceeds to buy more shares in the company.
Why would the investor want to do this? There are various reasons, such as the growth history of the dividend. Some companies have a dividend growth history spanning decades, meaning that they increase the annual dividend each year. Effectively, this shows the power of compounding because, as mentioned earlier, the higher the interest rate used for compounding, the bigger the earnings. In this case, the bigger the dividend, the more shares can be bought and the bigger the future dividend will be.
Such companies, called dividend “aristocrats,” are known for their long history of paying dividends and their high dividend payout ratio. Investors look at the dividend yield, which represents the share of the dividend at the current market price, and at other financial metrics to interpret whether the dividend policy is attractive in the long term.
Reinvesting Annual Dividends
Annual dividends act like interest earned on interest. For the sake of simplicity, let’s use another example.
Let’s say an investor owns 100 shares in a company that traditionally pays an annual dividend. Let’s also assume that the price of 1 share at the start of the fiscal year is $30. Therefore, the original investment amounts to $3,000. Also, for the sake of simplicity, we will assume that no commissions are paid to the broker for buying the shares.
By owning shares in a dividend-paying company, the investor stands to benefit from 2 potential sources. 1 is the potential for the company’s price to rise. If it does, the original investment will be worth more in the future. The other source is the reinvested dividend.
Let’s also assume that the investor receives $1/share as an annual dividend and that the dividend remains constant over the years. At the end of the first year, the investor receives $100 as a dividend payment and may buy 3 new shares by reinvesting the proceeds if the company’s share price remains constant. This means that the next time the investor receives a dividend, it will be a bigger payment because of the new shares added to the portfolio. Therefore, the dividend received for the 3 new shares is the equivalent of the “interest on interest” concept in the compounding process.
The reader can understand why companies insist that their investors reinvest the dividends received, and many present on their websites the potential performance of an investment with and without reinvesting dividends.
Non-annual Compounding
Annual compounding is 1 option, but it doesn’t have to be the only option. In fact, it is not, as, in the United States, publicly listed companies pay a quarterly dividend. As such, the compounding rate increases significantly because investors reinvest the quarterly dividends at a faster rate; thus, the interest on interest grows exponentially. In other words, more frequent compounding leads to higher earnings.
We know that the equity markets experience periods of consolidations, declines, and aggressive rises. Both bullish and bearish markets exist, and by reinvesting their dividends, investors stand to make more in bullish markets and offset some of the losses incurred during bearish markets.
In this way, in a bullish market, a portfolio will benefit from the stock price appreciation plus the compounding power given by the reinvested dividend. Conversely, in a bearish market, the decline in the stock price is partially offset by the reinvested dividends.
Are Non-Dividend Paying Stocks Bad Investments?
Some of you might be wondering at this point why anyone would invest in companies that don’t pay a dividend in the first place. Are they bad investments? No, they are not.
Here is Amazon’s all-time price chart. It reached more than $3,000 per share, with most of the growth coming in the last 2 decades. The moral is that some companies grow at faster rates than others, and this is certainly the case with Amazon.
But one needs to know how to find such companies, and this is as tricky as tricky can be. However, it is much easier to find a dividend-paying company in a rising industry.
Here is Microsoft. This is a company that pays a quarterly dividend and still has its stock price increasing significantly. Investors have earned much more than the chart below shows by reinvesting their dividends and letting them compound.
Compounding When Trading the FX Market
The compounding rate of different investments differs. In some cases, the compounding rate is well known in advance, or at least there is an educated guess about what an investment in a given industry might yield at the end of the forecast period. For instance, the Internet is full of studies showing the compounded annual growth rate (CAGR) for major industries for the next few years.
This alone helps traders and investors pick currencies to trade or companies to invest in. For example, if online streaming is forecast to have a CAGR rate of 20% over the next 5 years, most investors will favor buying stocks in companies offering such services, such as Netflix. This would be an even more appealing investment if the company is paying a dividend due to the higher compounding rate, as explained earlier in this article.
How about compounding when trading the currency market? Compounding in the FX market is more challenging than compounding when trading in the stock market, but it’s not impossible.
Here is what currency traders should focus on:
- Mind the swaps
- Focus on the bigger picture
- Add to winners
Mind the Swaps
When trading currencies, compounding is still possible if the trader uses swing trading or an investing strategy. Typically, compounding is possible when trading currencies with a long-term horizon for the investment, and positive swaps are there to help.
Swaps are positive or negative amounts of money added or deducted from a trading account when the trader keeps positions open overnight. Not all currency pairs pay a positive swap, especially now that interest rates are close to the 0 level in most of the developed world in response to the COVID-19 pandemic.
Nevertheless, positive swaps do exist, even though they are not as common as they used to be. But as the world’s economies recover from the economic recession caused by the pandemic, the central banks will adjust their monetary policies quickly.
Usually, swing traders and investors use fundamental analysis to build a position in the market. They also look at larger timeframes, such as the weekly or monthly chart, for technical confirmation. These traders are betting on a trend reversal or continuation based on changes in the economic developments in different regions and based on what the central banks are doing. For instance, if the Federal Reserve in the United States begins a tightening cycle but the European Central Bank does not have any intention to tighten, the gap between the 2 policies might warrant shorting the EUR/USD currency pair.
Such traders do not intend to pick the exact top or bottom of a trend but to build a position that will pay over time as long as the interest rate differential exists. 1 way to compound the earnings is to keep adding new positions in the same direction at regular intervals or at technical inflection points.
Another way is to use the proceeds from positive swaps and reinvest them by adding a new position to the original one. This way, reinvesting the positive swaps acts just like reinvesting dividends.
Not All Brokers Have Similar Swaps
Perhaps it is useful here to explain what a swap is and why it is different from broker to broker. Swaps reflect the interest rate differential between the 2 currencies that make up a currency pair. The bigger the gap, the bigger the swap received when buying a currency with a high interest rate and selling one with a lower interest rate.
But swaps differ from broker to broker, and even if the interest rate differential is positive and thus the trader is entitled to receive interest if buying a stronger currency against a weaker one, the swap may still be negative. How come? The answer is that forex swaps also contain a mark-up for the broker. This mark-up may be bigger than the positive interest; thus, the forex swap ends up being negative instead of positive.
Focus on the Bigger Picture
The bigger picture brings a different perspective to trading. By using the data on larger timeframes, traders can more clearly spot support, resistance levels, and confluence areas where the market might hesitate.
Also, by focusing on the bigger picture, it becomes easier to add to a position and helps filter the noise. Let’s use an example – check out the EUR/USD chart below.
The chart shows the price action since the 2008–2009 Great Financial Crisis, and we see that the EUR/USD pair was in a bearish trend the entire time, right up to the present day. By looking at the bigger picture, investors may add to their position, thus compounding their earnings for as long as the trend continues.
How do we know if the trend will continue? The series of lower lows and lower highs has not been broken, and as long as it remains intact, the market will remain under pressure.
Also, the bigger picture keeps traders on the right side of the market. Since the Great Financial Crisis, plenty of events have shaped the world as we know it today.
Fed’s Quantitative Easing
The Great Financial Crisis of 2008–2009 was a turning point in financial markets. For the 1st time, the Federal Reserve (Fed) of the United States introduced the concept of quantitative easing (i.e., central banks buy government debt using newly printed money).
The Fed needed 4 rounds of quantitative easing before the economic recovery was on track, thus flooding the markets with newly printed dollars. The process was projected to be highly detrimental to the American dollar, and many traders panicked and sold the greenback. As the chart shows, to this day, the periods when the Fed did quantitative easing in 2013–2014 proved to be great spots to add to a dollar-long position.
From that moment on, quantitative easing became just another monetary policy tool. Moreover, the unconventional measure was even expanded in the next crisis, as central banks have continued bringing creative solutions to ongoing problems.
ECB Cuts Rates Aggressively
A few years later, the ECB’s turn was to trigger another leg lower in the EUR/USD pair. Under the new leadership of Mario Draghi, the ECB launched a massive easing policy. It went as far as the central bank lowering the deposit facility rate below 0, something unthinkable only a few years earlier. As a result, the EUR/USD made a new lower low, once again confirming the bearish trend.
Mario Draghi has gone down in history as the ECB president who never hiked the interest rate even once during his 8-year mandate.
Trump’s Election
When Donald Trump was elected president of the United States, the U.S. dollar initially rallied. The market participants looked for the safety of the world’s reserve currency, so the EUR/USD pair headed toward the lows again. But as the stock market bounced back from the lows, the pressure on the dollar increased as a risk-on sentiment dominated. Thus, it wasn’t long before a reversal took place.
Macron Becomes President
Macron’s election as France’s president sparked enthusiasm among euro supporters. The EUR/USD opened with a gap higher the following Monday, and the gap remained open for a long time.
The rally in the EUR/USD pair was so strong and aggressive that the pair traveled to 1.25 from 1.03. Yet, as it turned out, the move higher was just another opportunity to add to a short position and to increase the compounding rate for a long dollar position.
Market participants viewed Macron as pro-Europe and European values. Moreover, because the European Union is built on the Franco–German pillar, the news was viewed as bullish for the common currency.
COVID-19 Pandemic
The COVID-19 pandemic in 2020 brought a worldwide recession. After immense monetary and fiscal support, the EUR/USD pair rallied from the pre-pandemic levels and ended the year above 1.23. Once again, the Fed in the United States opened dollar swap lines with other central banks around the world to make sure dollars were available and ease the strain on the financial system. As a result, the dollar declined against its peers, so the EUR/USD exchange rate rallied.
It looked like nothing could stop the dollar from declining, but the dollar actually gained against the euro in the following year. Once again, focusing on the bigger picture and filtering the noise helps increase a trader’s compounding rate by helping them stay on the right side of the market.
Add to Winners When Trading FX
Effectively, compounding on the currency market resembles reinvesting dividends when trading the stock market. However, in this case, compounding means reinvesting the free margin in a trading account because it grows proportionally with the profits.
Let us use an example here to better make our case. Let’s say that a trader is long on the EUR/USD pair from 1.15, and the position needs a margin of $2,000. Also, let’s assume that the trader has no other open position in their FX trading account and that plenty of available margin is still left in the account.
Fast forward a few days or weeks, and the EUR/USD exchange rate has jumped to 1.20. The free margin in the trading account has increased with the EUR/USD advance. Hence, if the trading setup is still valid, the trader may add to the winner the equivalent of a position that requires no more margin to be invested than the one gained by the EUR/USD advance. This way, the trader adds to the winning position, effectively “reinvesting their dividends,” or the profits, just like an investor in the stock market would.
Compounding When Investing in Stocks
We have already discussed how reinvesting dividends helps increase the compounding rate. Are there any other strategies that result in compounding earnings? Here are some to consider:
- Adding to winners
- Not averaging losers
- 10-baggers
- Letting winners run
- Cutting losses short
Add to Winners When Trading Stocks
Human nature often plays tricks on us, and financial markets are the perfect place to illustrate this. When trading, the best-laid plans may turn out to be useless, as when a trader enters a position, they are prone to alter their initial plan.
Fear, greed or lack of patience are only a few of the reasons why this happens. After all, if a stock doubles in price, what is wrong with booking the profits?
Booking profits is all well and good, but adding to winners is a better strategy that helps compound earnings in the long run. Let’s suppose you have an account funded with $10,000, and you want to start investing in 5 stocks.
After conducting due diligence and determining what companies to add to the portfolio, the investor splits the amount into 5 different portions and invests equally in each stock. As time passes, some stocks will perform better than others. If new funds are available and 1 of the stocks has doubled in price or grown even higher, the best choice is to add new shares rather than buying more shares in a declining stock.
This means that the company has done something right, and investors have rewarded it by sending the price higher. As such, it is best to add to a winning position rather than trying to average losses.
Do Not Average Losers
Just like in FX trading, averaging losers should be avoided. For instance, imagine that the stock price of 1 of your investments drops in half during the course of a year. While this may look like an opportunity, there is likely a reason for the decline – a shrinking market share, declining revenues, etc.
1 of investors' most common mistakes is not understanding how dollar averaging works. Dollar averaging is a strategy that investors deploy, and it involves keeping your average price for a stock below the current market price. For instance, if you bought fifty shares of Microsoft at $100 and then another fifty shares at $150, then $125 is your average price – well below the current market price.
10-Baggers Are Common
The term “10-bagger” refers to stock prices that have increased 10 times since the stock was added to the portfolio. While this sounds like incredible performance, 10-bagger stocks are more common than investors would like to think.
In other words, letting your winners run and adding at certain checkpoints will increase the compounding rate. For example, one may buy a stock and see that the price is rising rapidly. When it doubles or triples in price, instead of booking the profits, a better strategy would be to add, as, again, 10-baggers are common.
Let Winners Run
Letting winners run is another 1 of those investment strategies that sounds so simple, yet investors have a hard time following it. Once again, greed plays a trick on us, and we are tempted to cut our winners to book the profits and keep our losing investments in the hope that they will break even eventually.
There is nothing more painful than seeing the value of an investment decline – especially if it does so rapidly. For example, think about the COVID-19 stock market decline in 2020. In retrospect, buying the dip looks like a great decision now. Still, at the time, the market dropped so aggressively that the main U.S. indices triggered circuit breakers – levels of protection when the market declined more than a certain percentage during a single session.
As such, traders that panicked and held on winning positions may have sold into the decline only to see the market soaring in the weeks after. Therefore, if a stock has performed well in the past, the best way to compound it is to let it run.
Cut Losses Short
As painful as it may sound, a trader or investor must be able to cut their losses short. By not taking action when needed, an account’s performance is damaged in the long run. If the market declines but an investment still shows a profit, the best way to compound is to buy the dip if the average cost remains above the current market price.
But if an investment “goes under” or shows losses, the trader must have an exit plan in mind. This may differ from trader to trader and from strategy to strategy, and it is typically either a stop-loss order set at a certain level or a certain percentage of the initial investment. In other words, the trader must know in advance the tolerance level – the level that would invalidate the investment – and when to exit.
What should a trader do with the proceeds – i.e., what is left after cutting the loss short? The right answer is to invest in other stocks that are still showing positive results.
Examples of Compounding Strategies
Here are a few examples of compounding strategies to use when investing in the stock market. They lead to a higher compounding rate either by reducing the cost of trading, in the case of ETF trading, or by increasing exposure, in the case of reinvesting dividends.
Buying Long-Term ETFs
Long-term ETFs are passively managed exchange trading funds. In contrast to actively managed ETFs, long-term ETFs invest in stocks in the long term and are a great investment option for long-term buy-and-hold investors. ETFs are pooled investments, and 1 of the things that attract investors is their cost-efficiency to hold in the long term.
Reinvesting Dividends
Reinvesting dividends is a strategy we already covered in this article, but it is worth mentioning again. It represents the best way to compound earnings in the stock market, and investors must pay special attention when picking dividend stocks.
For instance, a company with a long history of paying dividends is more attractive. Some companies have paid a dividend for more than fifty years, for example, meaning that there is little to no risk of going out of business and changing the dividend-paying policy in the future.
Another thing to look at is the dividend growth history. A company’s management may decide to constantly increase the dividend to keep its stock attractive to investors, which is another way of compounding.
Add upon Stock Buyback Plan Announcements
Stock buyback plans are viewed by many as a company trying to manipulate its stock price. However, that is not true – they are just another way to reward shareholders.
1 of the most important financial metrics when interpreting a company's financial statements is the free cash flow position. Effectively, this shows how much cash is left after the company covers all the costs of doing business. Naturally, the bigger the number, the better.
A company has multiple options for using the free cash flow. For example, it may use it to fund expansion into other markets, launch new products or services, buy out a competitor, or pay down debt.
Another option is to start a stock buyback plan. Such a plan is usually announced during earnings conference calls when the company's management provides future guidance. A buyback plan suggests that the management believes that the current stock price in the market is too low and thus does not reflect the intrinsic value.
Because of that, it plans to buy back its shares from the market. The bigger the plan, the better for the stock because the company will support the price on every dip.
However, the stock price will not necessarily increase as a consequence. Examples exist of a stock price continuously declining even though the company’s management spent tens of billions to buy back floating shares.
Conclusion
Compounding is a great concept that lets investors reach their goals faster. The phenomenon is also known as “interest on interest,” and it requires that the original investment is not withdrawn.
Compounding works both in the stock and the currency market. Various strategies exist, and some of the most popular ones have been presented here. This article should act as the cornerstone of this trading academy because it prepares traders, who typically have a short-term horizon, to become investors.
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