Compounding for Robinhoods
One of the most popular concept of invetsing is the “power of compounding”. Almost every prominent investor and financial author has emphasized on this concept.
The principal of compounding, insofar as financial investments are concerned, works on the basis of three key factors (a) regular investment; (b) staying invested for long period; and (c) rate of compunding. To take full advantage of the power of compounding, it is therefore essential to:
(i) Invest regularly;
(ii) Reinvest the return on investment; and
(iii) Try investing at the maximum possible rate of return, without of course compromising the safety requirements.
Does this imply that the concept of compunding is relevant only for investors who could “buy and hold” an investment for sufficiently long period of time?
This question is more pertinent to answer is whether the concept of compounding is relevant for stock traders also; especially when currently the markets are being dominated by the “Robinhoods” – the individuals indulging in short term (mostly daily) trading in stocks.
I beleive that compunding does work for the day traders and short term traders also. In fact it works more hard for them as it impacts them on both the sides, i.e., in gains and in losses. For example, consider the following:
(a) If you buy a tocks Rs100 on Monday and it rises 10% on Tuesday, the gain is rs10 and the closing value would be Rs110. If the stock rises 10% again on Wednesday, the gain would be Rs11 (10% of Rs110) not Rs10. And so on.
(b) If a trader buys a stock on Monday at Rs100, and it rises by 10% on Tuesday, the gain is Rs10. However, if it falls 10% on Wednesday, the loss will be Rs11 and not Rs10.
(c) If a traders buys a stock at Rs100 and it falls by 25%, the value of the stocks wouild be Rs75. It would now need 33% gain in stock price for the trader to recover his cost. If the fall is 50%, the gain required to break even would be 100%.
If you find it too simple and nothing much to bother about, add the transaction cost to these examples. In case of traders, the transaction cost of aposition compunds witrh every trade. This is the most ruthless element of the entire trading process. It does not care if the trader is making or losing money. It just keeps gnawing on the capital of the trader with each trade he executes. To under stand the magnitude of this consider this example.
A trader pays 0.2% for a delivery settled trade. The total transaction cost, including l;evies and other charges would come to appx 0.4% in his case. If he rotates his position five time in a month, assuming there is no net change in the price of stock he would have paid 4% as transaction cost only, i.e., massive 48% per annum. If he repaets this feat for one full year, he woould have lost 48% of capital in transcation cost only.
The case would be worst, if he is trading by using margin financing. The cost of margin financing (ranges efectively between 12% -30%) also keeps compounding each day. In many cases the etire capital of traders gets eroded just by transaction cost and margin interest.
It does not stop here. There is another devil eyeing the capital of the trader. If the trader sticks to a losing position for over one yyear and then switches to another “rocket”, which would give enough return to make for the losses of the dud, the finance minister may not spare you. The losses of “dud” in this case would be long term and gains of “Rocket” would be short term. The trader will end up paying 15% tax on these gains!