Albert Einstein – yes, he of “e equals mc squared”, said that compound interest was the greatest mathematical discovery of all time, and this brief summary might just convince you how right he was.
When one first examines a potential investment, it is natural to look at the headline expected rate of return, but it is the compounding of the interest (or profits) on that principal which creates the biggest returns over time.
The compounding of profits, or dividends, or interest applies in all financial markets, so if you are a short term stockmarket trader, property investor or other short or long asset holder, you may find the magic of compounding interest very interesting. We will see here though how using CFDs and compound interest can provide potentially astonishing returns.
The rule of 72 and long term returns
You might not have learnt this at school, but Einstein’s rule of 72 is one of most magical and simple formulas around. What this says is that to work out how long it takes to double the value of an investment, you simple divide the return into 72.
So, if we say that the stockmarket has returned around 11% on average over the last one hundred years or so, (and property is not far behind for that matter), then to work out on average how long it would take an investment in the market to have doubled, the calculation is 72 divided by 11, which equals about six and a half years.
A few quick points need to be made clear here. First, this rounded figure assumes all dividends are reinvested, and there are no charges for investment, which clearly is not realistic for most investors. It does not include taxes of any sort, which again would have to be factored into potential returns.
Doubling and doubling again
Once we have the time it takes to double your money, this is where the magic of compounding comes in, because it becomes possible then to extrapolate some very tasty figures over the longer term.
If we return to long term equity investment, and say that the real return on shares (that is adjusted for inflation and charges) is say 5%, then you could work out how much would you need to invest and how long to give you a future investment value of say £1m in today’s money.
A simple spreadsheet model can do this, but let’s say you began with £10000 and each year your investment appreciates by 5% in real terms. To double the initial figure would take (72 divided 5 approximately) just over fourteen years. Another fourteen years is what it takes to double again, and after 42 years of working life, your £10000 becomes £77615 in real terms. Now this doesn’t sound much, but of course this does not include any further contributions you make through your working life.
But going back to nominal returns, the story is dramatically different. Assuming a round 10% per annum returns after costs, it takes just over seven years to double your money. After 42 years, your £10000 is now worth £547637 – a quite amazing figure. Now you can see the linkage with the trend of property prices based on these long term returns from the past, but as mentioned before the figures for total return on the stockmarket (not just how much the indices have gone up) is even higher.
Just to show how this sort of compounding works in the real world, Warren Buffett began with $105,000 fifty six years ago – it was a lot of money admittedly then. His fund’s compound returns have been around 25% per annum, and his fortune is currently over £50bn, making him the second richest man on earth.
Monthly returns and hitting the magic million
How then does all this relate to the short term and in particular to CFD trading? The first thing we have to presume is that a good trading methodology is crucial to all traders, whether it is in equities, indices, forex or commodities. It is then possible to leverage short term investments for spectacular gains within just a few years.
Let’s return to our fictional £10,000 starting investment, but this time we’ll measure performance in months, not years. A very good trading system might return 1.5% per month after costs, which compounds to 19.6% per annum. This is not far off the sort of figure that only the best hedge funds aim to match or beat over the long term.
Without leverage, the £10,000 becomes £24432 over five years, which is a pretty good return on its own.
Using just three times leverage however the return jumps to an astonishing £140274 over just five years.
You would theoretically hit a million in less than nine years, and that’s just from £10,000!
A word on risk/reward
All the above simulations (with the exception of Warren Buffett) are based on average long term returns and take no account of short term movements. CFD traders should of course be aware that by increasing your leverage, the risk of major falls in equity increases accordingly.
It is paramount that all traders have applicable money management systems and stop losses in place to protect against potential pitfalls when trading, but by using CFDs with a profitable trading system and leverage, the sky really is the limit.
Mike Estrey is the Head of Research for Blue Index, the Day Trading specialists in Contracts for Difference . Foreign Exchange Trading also forms part of their extensive services.