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I shared the following story with some of my students recently in a gathering session. It’s not surprising to hear that some students feel that they are ready for live trading and, thus, fund their accounts. So, here is the question: How much do you think you should wire to the live account as a start? Some say $2,000. Some say $5,000. Some even say $25,000. Obviously, there is no right or wrong answer. However, whatever you think to be appropriate, I would like you to spend a few minutes to allow me to share with you the power of compounding. Whether you are day trader or position trader, or a trader trading once a month, it is of crucial importance to understand the power of compounding.

Let’s say you have $2,000 in your account and your target is to make an annual return of 10%. Do you know how long it will take to double your account to $4,000? There exists the golden rule, called “the Rule of 72.” Of course, I have no idea of this magic number “72” comes about. What I understand is that if you dividend 72 by 10 in this example, the answer is 7.2. What this means is that it takes 7.2 years to double your account to $4,000. However, if 10% return is on a monthly basis instead of an annual basis, then it means within 7.2 months, you will double your account. Let me ask you this question: Are you able to achieve a return of 10% a month in your portfolio?

I assume that all of us know who Warren Buffett is—the father of value investing. It has been said that Buffett is able to achieve an average return of approximately 25% annually. By using the Rule of 72 formula, you will now understand that it takes only 2.88 years for Buffett to double his money. Again, let me ask you this question: Are you able to achieve a return of 25% a year in your portfolio?

No matter what answer you have, I hope you will understand the power of compounding, and it is pretty important in the financial world.

Let’s put ourselves in this situation where we have only $2,000 to invest and our goal is to achieve a monthly return of 10% consistently. If everything goes smoothly, you will be able to multiply your $2,000 account by almost 10 times by the year of the second year as shown in the table below.

Let’s investigate this table further. You will see that after the first few months, your account is crawling up as slow as tortoise. By the end of the 5^th month, you will only increase your account size by a mere 50%. As proven by the Rule of 72 formula, you will double your account within the 8^th month. Do you notice that by the end of the first year (I mean just 4 months later), you will triple your account? After this, you will be able to quadruple your account in another 3 months’ time. In fact, from the 15^th month onwards, you will see the acceleration in your account and the account balance continues to skyrocket.

So, do you see a need to fund $10,000 account compared to $2,000? Which is better? The key I wish to stress is with the power of compounding, you can turn a $2,000 account into a $20,000 account in just 2 years provided you are able to achieve a consistently monthly return of 10%. Of course, with the tortoise pace initially, it is not enticing to the newbies because most of them enter into this business with a view to making a killing in the financial market. So, if I were to tell them that they should be aiming at 10% return a month, they may be upset because others have told them that they made 300% or 7,000% in just a day. Why should they settle down with a 10% monthly return? Oh well, do you still see these people around you nowadays? Can they make 300% or 7,000% consistently? If not, please re-think what they have told you and appreciate that sometimes, consistency is the key.

Please share with me your comments in my discussion board as I would like to hear your story.

To access previous articles written by Jack Wong, please click here.

Jack Wong 
Staff Writer
Optionetics.com ~ Your Options Education Site
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