Traders Can Clench the Power of Compounding Returns. Here’s How

One of the primary arguments for long-term buy-and-hold investing is that it allows you to compound your returns. Compounding has been called the most powerful force in the world. Supposedly Albert Einstein called compounding the “Eighth Wonder of the World.”

Investopedia defines compounding as “the process in which an asset’s earnings, from either capital gains or interest, are reinvested to generate additional earnings over time.” Benjamin Franklin described it as: “Money makes money. And the money that money makes, makes money.”

The traditional investment example of this is holding a single stock over a very long period. The constant reinvestment of the capital gains produces a compounding effect, so you earn gains on your gains. This is what has made Warren Buffett an investment icon. He has simply held some great stocks for a very long time, and the power of compounding has made him one of the richest men in the world.

There are many illustrations of the power of compounding. One of the most interesting is that if the $24 that was used to buy the island of Manhattan from the Lenape in 1626 was invested in a bond at 8%, it would be worth about $26 trillion as of 2012.

There are compound interest calculators on the Internet that you can play with to get a feel for the power of compounding, but the magic is a function of consistent returns over a long period of time. High levels of consistent returns over the longest possible time frame will make you rich.

Most investors think of compounding only in terms of long-term buy-and-holding of a specific stock. Typically, people try to copy what they think Warren Buffett does. They buy just a few great stocks that they are sure will continue to rise steadily over a long period. In retrospect, it is easy to find things such as Apple  (AAPL) , Microsoft  (MSFT)  and Google (GOOGL) . It is a much more difficult process when you try it on a prospective basis. What stock can you buy today that will act as Apple has over the past 20 years? If we knew the answer to that question, we’d all be sailing on our yachts in the Caribbean.

The big risk with buy-and-hold investing is that you are in the wrong asset. Compounding works in reverse as well. Holding a stock that doesn’t appreciate for many years is the more common situation that investors face and it is extremely costly.

You can still benefit greatly from compounding without holding just one stock for a very long time. You do that by making sure that the asset you are holding stays near its highs at all times. With a bank account, you don’t have this problem. The dollars you invest don’t go down in value but the level of returns will be very limited. With stocks, there will always be the risk of loss, and that is what will kill the compounding effect if it lasts too long, but there is also the potential of much greater average returns over a long period of time.

If you think of your portfolio of stocks as a single asset, it changes your focus. The aggregate of all the stocks that you hold can be viewed as the equivalent of simply holding one stock, such as Apple. However, this requires you to manage that asset via active trading.

Ultimately all that matters is that the portfolio remains near its highs and produces some level of returns over a long period of years. The fact that you may have made thousands of trades in hundreds of stocks doesn’t curtail the power of compounding. It may actually enhance your returns. Even stocks like Apple suffer drawdowns of 50% or more on their upward trek over many years. It is possible to reduce volatility through very active trading if that is a primary focus.

Rather than just try to find a few good stocks to hold, focus on carefully managing the stocks you do hold. Those that don’t help keep your account near highs are eliminated, and those that help it grow faster are added. If you do this effectively, your asset base will grow, and the compounding effect will be even better than that enjoyed by passive holding over the very long term.

Obviously, this approach is more work than finding a single great stock to hold for a very long time, but it also reduces risk. If your account is going the wrong way, you cut your losses, regroup and look to find the stocks that will perform better in the future.

Most people fail at compounding their investment accounts, because they suffer too many big drawdowns. They don’t keep their accounts close enough to highs. They suffer a big loss and then must go through the very unproductive task of just returning to the point where they were.

Think about your portfolio as if it were a single asset that you are going to grow at a compound rate for many years. Stay focused on keeping drawdowns relatively small. It doesn’t matter what stocks you own or your holding period. What matters is keeping that account as close to highs as possible for a very long time.

Active traders are in a far better position to benefit from compounding than buy-and-hold investors if they do it right.