Compound interest: eighth wonder of the world

“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” – Albert Einstein

This is a very broad topic, so I’m going to keep this specific to the context of trading and the power of compounding returns. This is relevant to any financial market traded.

Let’s first consider two simple money management techniques a trader can employ into their strategy when trading the markets.

1. Fixed trade size (monetary)
2. Percentage trade size (proportional to trading balance)

The first option would suggest that no matter what the outcome of the previous trade (win or loss), the same fixed monetary trade size will continue on any future trades. So, how might this apply in the case of a profitable trader?

Let’s assume there are two traders (Sam and Ben) who have the same strategy and balance:

• Deposit: $10,000
• Winning percentage: 55%
•  Profit ratio (ave. win / abs(ave. loss)) = 1.2

The information above is limited, however it gives us a base in which to construct a visual representation of the growth on each traders account.

Below is a graph simulating Sam’s performance which uses a FIXED TRADE SIZE of $100 on each trade he takes (that’s to say, each loss will cost him $100):

It’s important to make a side-note here. Here is only one simulation of what a distribution of wins and losses might look like on a line chart. Keep in mind that we could have seen an unprofitable outcome. Because when we’re trading the markets, we never know the outcome of each trade,  nor do we know when a string of losses will occur. Instead, over time we should be profitable the more we trade.

Getting back to the point, using fixed trade sizes above, we can see that this yielded +16% growth: (end balance less start balance) divided by end balance.

Now let’s consider how Ben traded based upon a FIXED PERCENTAGE of his balance. The fixed percentage will be 1% of the balance at the time Ben opens his trade, starting at $100:

Using 1% of his available balance at the time Ben opens each trade, over this simulation of 40 trades he’s yield (or made) +9.58% growth.

So, wait a minute, the fixed bet size on each trade seems the better option?

If you think that now, please let me enlighten you.

As I alluded to earlier, these are small simulations (or what a statistician would refer to as ‘sample size’) and it’s not necessarily indicative of what can be achieved ‘over the long-time’.

Let’s now put both betting systems next to each other but this time compare what 1,000 trades could look like:

Here are the comparative returns:

1. Fixed betting: +208.6%
2. Fixed percentage: +1,211.5%

Over the short term we’ve observed Sam achieving a slightly superior return to Ben, however, over the long term Ben has gone on to buying his yacht while Sam is still in his row boat. The only difference between them was that one compounded his gains and the other didn’t.

I hope you’ve come to understand there are two lessons within this article. At the forefront, I’m highlighting the power of compounding returns through the use of fixed percentage risk for each trade. And I’m also hoping you’ve also learned that referencing a few trades isn’t always a healthy way of assessing whether your strategy has a positive ‘expectancy‘ which means it is likely to stand the test of time.

More on this in future articles.