If you are an investor, you might already know about compound investing. But what about compound interest trading? And how to start compound trading?
Starting compound trading can transform your investment strategy. This approach utilizes the power of compound interest, where the interest you earn generates additional interest over time.
Understanding the rule of 72 helps you estimate how quickly your investment will double based on a given interest rate. Mastering compound trading is crucial whether you’re focused on long-term investments or seeking a specific rate of return.
It hinges on how interest accumulates over the years you invest, significantly boosting the potential returns. Dive into the mechanics of compound trading to leverage these principles effectively in your financial portfolio.
What is Compound Interest?
Let’s start with the basics before we show you how to start compound trading. According to one of the greatest scientists, Albert Einstein, compounding represents the world’s eighth wonder.
In the world of investing and trading compounding is a magical strategy to make your money grow. But what is a compound strategy in trading? And how it differs from compounding in traditional investing. Before we tackle compound interests in trading let’s see how it works in traditional investing.
In traditional investing, the principle of compound interest is quite simple. The interest generated on your capital is directly added to this capital to be integrated into the next interest payments.
When you invest money, you earn interest on the money you invest and, later, on the interest you have accumulated by investing your money. Your money earns you interest, which in turn earns you interest, and so on.
Let’s take an example. Invest €1000 at 5% per year for 3 years:
Year 1: €1000.00 at 5% or €1050.00 (€50.00 interest).
Year 2: €1050.00 at 5% or €1102.50 (€52.50 interest).
Year 3: €1102.50 at 5% or €1157.62 (€55.10 interest).
Each year, the interest earned increases. In the long term, that is to say, over several decades, they can reach colossal proportions. For example, when you invest for retirement, the capital you will obtain in the long term will mainly be compound interest.
How Does Compound in Trading Work?
Compundt trading involves leveraging the potential of regular small profits to reach long-term financial growth. It’s similar to the snowball effect. The ball, as it rolls, grows larger. Let’s see how it works.
Simply put, compound trading consists of you pocketing profits and reinvesting them. But you might be asking why you should reinvest the profits. The answer is simple: exponential value growth. If you regularly reinvest your profits, you maximize the potential of your initial investment. And eventually, it leads to considerable gains, particularly compared to trading strategies where gains are regularly withdrawn.
Example of Compound Trading
A trader begins with an initial investment of $10,000 and sets a 5% monthly return goal using specific strategies. He chooses not to withdraw his profits each month but to reinvest them. Here’s how the magic of compound trading unfolds over a year:
The trader reinvests the 5% profit each month, which adds to his initial capital. This means the investment base grows larger with each passing month. By reinvesting, he harnesses the power of compound interest. Each month’s gains build on the previous month’s total, not just the original investment.
For instance, after the first month, the trader’s account grows to $10,500. By reinvesting the $500 gained, he increases the capital that can earn interest. The following month, he earns 5% on $10,500, not just the original $10,000. This process repeats each month.
As the year progresses, his account doesn’t just grow linearly; it accelerates. The increase in his trading account is exponential because each month’s gain is a bit larger than the last. By the end of the year, this consistent reinvestment and accumulation of gains significantly enhanced the value of his initial $10,000 investment.
This strategy of reinvesting profits rather than withdrawing them allows the trader to maximize the benefits of compound interest, turning a substantial profit by year-end due to the cumulative growth of his investment.
How to Start Compound Trading?
Compound trading excites every trader, and rightly so. But how do you start?
- First, deposit an initial amount into your trading account. This is your base capital, and it kickstarts your trading journey. The amount will depend on your financial situation and how much risk you’re willing to take.
- Next, you must develop and backtest a trading strategy. Create a trading plan and test it against historical data to see its past performance. This step is crucial as it allows you to fine-tune your strategy and spot potential problems before trading with real money.
- Then, consider using a compound plan template. This helps you determine how much of your profits to reinvest and how often. The aim is to balance maximizing growth through reinvestment and taking some profits.
- Finally, the key to compound trading is reinvestment. Reinvest your profits back into your trading account. This compounds your capital growth because you earn returns on your initial deposit and the reinvested profits.
Compound Trading – Pros and Cons
Now that you understand how to start compound trading, let’s tackle its pros and cons.
PROS of Compound Trading
With compound interest, if the returns are positive, your savings earn more each year than the previous year. Therefore, the earlier you start saving, the more you will benefit from the power of compound interest. It’s the snowball effect: time is on your side.
If you do not have a large amount to invest and are rather cautious (which limits your potential return), time can still allow you to get rich, thanks to compound interest.
CONS of Compound Trading
After reading the above, you understand that investing at 10% for 10 years yields 100% (10 x 10%) with simple interest but probably more with compound interest. Indeed, investing at 10% for 10 years yields 159.4%, thanks to compound interest.
Thus, 1000 euros becomes €2000 with simple interest but €2,594 with compound interest.
Now, let’s apply the same reasoning to fees. Let’s imagine that this same financial product bears annual management fees of 3%. After 10 years, how much fees will you have paid? 30% or €300? Alas, this is false.
Let’s resume our investment at 10%. After fees, it only earns 7% per year. The capital obtained at maturity becomes €1,967 in compound interest. The shortfall, €627, means you paid 62.7% in fees during these 10 years (compared to the initial capital).
How to Take Advantage of Compound Interest
Nothing could be simpler to benefit from compound interest; place your capital in savings and leave it there! If you have an A booklet, you already benefit from it, except that the rate is so disgusting that you are not likely to see your capital increase. What to do then?
1. Management Funds
Your bank can offer you management funds, your capital will be invested in various products by a third party, and you will perform better than on a savings account. We will tell you that performance is not guaranteed, and that is logical. But you will still have a better chance of getting a better rate. Small downside, as a third party manages the capital, the bank will take its share of the added value. Ultimately, the performance will not necessarily be there with this solution.
2. ETFs/Trackers
These are funds, as in point 1! Except in this case, these funds replicate the performance of an index or a sector, and a third party does not manage them. This is an interesting solution because if we look at the average growth of the CAC40, we see an average return of 3.6%, which is already better than the banks. However, this average return is significantly reduced by the crashes of 2001 and 2008. If we look at the average performance from 1991 to 2000:
By adding up the performances from 1991 to 2000 and dividing everything by 10, we have an average annual growth rate of 16.147%: not bad, right? Performance also depends on the economic context; therefore, investing at the right time can be very interesting.
One last figure for your information: the average annual performance over the last 10 years is 4.6%
3. Invest Your Capital in the Stock Market Alone
A final solution is to invest in the stock market yourself, and that’s where it gets scary! And yet, it is not that complicated and with a minimum of knowledge, there is a way to limit the risks greatly! With this solution, achieving an annual performance of 10% is perfectly achievable, and to do this, it is possible to devote only one hour per week or even less!
Conclusion – Does Compound Trading Work?
To succeed with a compound trading strategy, you must consistently generate a monthly fixed percentage return. This task is challenging but highly rewarding over the long term. The magic of compounding works best for those who can consistently profit over time. The crucial step in becoming a successful trader or active investor using compound trading is to develop a successful trading strategy. You must find trading strategies that suit you, backtest them on a demo account, and then apply them to a live trading or savings account.
