The Problem With Compounding

Nov. 11, 2020

There’s one thing I’ve learned over the years:

Be very skeptical of conventional wisdom.

It’s bad enough when it’s flat-out wrong.

What’s worse is that sometimes the “wisdom” itself is the main obstacle to success.

For example, you’ve probably heard the phrase, “Keep your eye on the ball.”

Good advice, right? It’s still regurgitated on tennis courts all over the world by pros and students alike.

It’s awful advice.

First, no one really watches the ball onto the strings. Our eyes stop tracking the ball a few feet out in front of us. Second, anyone trying to get better by keeping their eye on the ball almost certainly will not get better. You don’t improve by working on something that’s completely false.

In trading, though, there’s one bit of conventional wisdom that’s untouchable.

Even Warren Buffett says it.

And that wisdom is, “Always compound your gains. Compounding is the 8th wonder of the world.”

That has to be true, right?

Well…

Let’s do a quick example.

According to testing, the Dragonfly should have made $13,067 this year trading 1 lot each time.

Imagine what compounding would do!

According to testing, if we started with the same trade size and compounded every trade (increasing trade size when we win and decreasing trade size when we lose), testing shows that our profit would have risen to… $13,459.

But that’s not the full story. Drawdown increased when we compounded.

Looking at the Profit Factor, it was higher when we didn’t compound (1.57 to 1.55).

So far in 2020, it would be better if we didn’t compound gains.

For fun, let’s look back a few months. Through 8/8/20, NOT compounding made $9,608 while compounding made $9,593.

After eight months, compounding was actually worse. 

Why is that? What’s the weakness of compounding?

I thought it was the 8th wonder of the world.

The problem with compounding is that you’re at your highest trade size when the losing streak comes.

For example, you win, you increase size. You win, you increase size. And so on.

When the winning ends, you’re stuck with a much bigger trade size, which makes the losing trade much larger than it would have been had you kept size constant.

When you compound that way, you’re vulnerable to massive drawdowns. True, you’ve already made money when the massive drawdown hits, but it’s massive nonetheless.

So, what does that mean?

Should we not compound at all?

In our next email we’ll look at when and if compounding our gains on every trade becomes a wise thing to do.

Talk soon.

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Disclaimer:
It should not be assumed that the methods, techniques, or indicators presented in these products will be profitable or that they will not result in losses. Past results are not necessarily indicative of future results. Examples presented on these sites are for educational purposes only. These set-ups are not solicitations of any order to buy or sell. The authors, the publisher, and all affiliates assume no responsibility for your trading results. There is a high degree of risk in trading.

HYPOTHETICAL OR SIMULATED PERFORMANCE RESULTS HAVE CERTAIN INHERENT LIMITATIONS. UNLIKE AN ACTUAL PERFORMANCE RECORD, SIMULATED RESULTS DO NOT REPRESENT ACTUAL TRADING. ALSO, SINCE THE TRADES HAVE NOT ACTUALLY BEEN EXECUTED, THE RESULTS MAY HAVE UNDER- OR OVER-COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED TRADING PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN.