Compounding is the ability of an asset to generate income, and that income to generate further income. As attractive as the concept appears it is still a double edged sword to the investor, who can only consider compounded returns as the fruits of the market.
Of course in a bull market that endures for a lifetime, it is difficult to see the truth of this allegation. Particularly when consistent returns are made year in and year out, the sheer weight of the numbers will show the benefits and power of compounding.
However, in most markets, returns are not linear and certainly not always positive. Indeed, reality demands that at times returns will be volatile, while at other times they may even be negative. In the same manner that compounding in consistent environments builds wealth exponentially, varying or negative returns will have the commensurate compounded effect on investment capital.
Returns that vary dramatically from year to year and also negative returns will erode the principal invested through not only a comprising of the compounded return, but also establishing a greater return that is demanded in order to simply breakeven. It seems the slings and arrows of life show no mercy to capital investment either.
Far from the investment rhetoric often heard to extol the virtues of compounding, these types of claims are based upon average returns and not compounded returns. Considering that only the latter are available to investors, this line of argument is quickly revealed to be the misleading diatribe that it is.
Quite contrary to what many would have investors believe, the art of compounding is more than simply not withdrawing from the investment any returns that it may produce. In order to ensure security of tenure, an investor needs to not only be active, but actually productive in asset management.
In an attempt to reduce the volatility in returns and maintain consistency, unnecessary expenses need to be eradicated. This necessarily means actively monitoring positions and taking such decisive action as implementing stop loss orders. Trailing stops on profit will ensure that favorable moves are not squandered back not the market due to inattention. The prioritizing of investment choices and relocation of capital is essential, particularly when profits need to be realized.
Gone are the days of passive investors that reaped the benefits of compounding. In a dynamic and increasingly competitive financial market place, the power of compounding is only achieved through active pursuit of sound capital management.