Compounding – Advantages and Disadvantages, Compounding Investing Pros and Cons

Friday, April 3, 2009

Compounding – Advantages and Disadvantages

Compounding is the process of reinvesting the previous earnings (profits) to generate more profits. For example suppose a trader makes 5% profit as an average per trade and his initial position size is $1,000. By keeping the position size constant for consecutive traders (e.g.: 5 trades) he can achieve a profit of $250 or 25% of his initial investing capital. If the trader is compounding, after 10 trades the trader can have a position size of $1276.2 and a total profit of $276.2 or 27.6% of initial investing capital. More over the position size grows continuously (1000, 1050, 1102.5, 1157.6, 1215.6…) and the trader can make more profits.

Advantages of Compounding

Many times compounding works like Dollar Cost Averaging (DCA) and the traders can continuously grow their portfolios.
Traders can start trading with risk-free trading capital and can grow their capital.
Compounding can be done in any style of trading, instrument and market.
As the trader is risking only the initial amount, there is no actual increase in capital-loss risk with increasing position sizes.
Good for traders who look for long-term portfolio growth (e.g.: retirement investing).

Disadvantages of Compounding

Compounding needs experience and market knowledge because there must be more winning trades.
Compounding needs good money management and is not so suitable for traders who trade for livelihood (who lives on profit from investment).
Compounding is also not a good strategy to follow when the returns are too volatile.