Defensive Money Management Explained: The Power Of Compound Growth
Whenever I talk about trading model performance, I avoid talking about exact amount of money to be used and how that can work for you if you put all the gains from trading back into the system for compound growth. There are many reasons why it is better to focus on consistent model performance. However, it is also important to understand the concept of compound growth and how to utilize it when the time is right.
(Part of Defensive Money Management Explained series)
The Magic Of Compound Growth
Here is an example of the usual pitch from trading system vendors with the corresponding equity chart.
"Hypothetical Compound Growth of $100,000 trading XYZ"
Well, taking $100,000 to more than $2,000,000 is sure a great accomplishment. Trading models with this kind of performance are often asking for $1000 to $2000 or even more.
This makes you want to buy it right?
Wait, take a look at the following equity chart on another trading system first.
This system took $100,000 to $18,000,000 in the same 20 years. This cannot be true.
Can there be real trading systems that works like that? You bet.
The chart above is the hypothetical compound growth result of my trading system, Bankable ETF Strategy: Simpleton Counter-Trend available for free at Seeking Alpha, with the same amount of $100,000 initial capital traded for 20 years.
One of the reason I do not try to brag about the trading models I have created is that they are too good to be believed by normal people when the equity chart based on compound growth is used.
Normal people can believe that a trading system can take $100,000 to 2 million dollars but they cannot accept that a trading system can take $100,000 to 18 million dollars. They are bounded by their personal belief system of what is possible and what is not. Can’t blame them.
(By the way, if you have bought trading systems that cost you $1000 or more and not satisfied with their performance, give my free trading systems a try. They are listed in the S&P Signals page. You can pay me a few thousand dollars later.)
How Do Compound Performance Charts Really Work
Compound growth of a trading system is based on the idea of increasing position size using the profit accumulated from trading. It works in the exact same way as any other compound interest gimmicks. The equity chart based on compound growth is a gimmick to exaggerate the potential gains so that the potential customer will be motivated by greed to make a deal quickly.
To illustrate the point we can use the following chart to show how compound performance would produce an illusion of spectacular performance easily.
The chart above is showing the compound performance of 5 trading models. Each one has an average annualized rate of return from 8% to 16%. If I show you the non-compound performance chart on these models, the performance lines will be 5 (almost) straight lines very close to each other. By using the compound growth chart, notice a 2% difference in average performance by the end of 20 years of trading is amplified into more than $500,000 easily.
In short, although the hypothetical compound performance charts are illustrating something that is potentially true, it places so much focus on the ending equity levels that it often does more harm than good to the person looking for a trading model to work with.
What To Look For From Compound Performance Charts
When a trading system is showcased by compound performance chart, it is important that it is showing a near perfect parabolic curve going up as time progresses.
Should you find that there are big jumps in the curve and long steep declining periods, it implies the model is unstable. It is possible that the model has been curve fit to work best with the historical data. For a model like that, only close examination can tell if it is stable or not.
A model that is overall pretty stable can go near flat in equity for prolonged period of time when compound performance chart is used. It is a sign that the system was not performing during those time period yet it has characteristics making it resistant to drawdown. It is a good sign the model is consistent in its performance.
In general, it is better to look at the non-compound performance chart and the actual trades made by a trading model than relying on the compound performance chart for better understanding of the model. The compound performance chart is really for show only.
Compound Growth Is The Corner Stone Of Trading For Wealth Building
Although compound performance charts are not really useful in telling us the true performance of a trading system, it does not imply the use of compound growth strategy is wrong. In fact, it is necessary to use compound growth to build up your trading capital. It is the reason why trading is a scalable business.
The concept of compound growth is often ignored in the beginning by many traders. They often have a specific goal in mind on the amount of money they want and how much is enough, say, on a monthly basis. That thinking is a result of the social norm and also the normal expectation from working on a salary. This belief leads them to think within the context of having a regular job instead of having a business of their own.
With compound growth being part of a trader’s core belief, it opens the door to all kinds of trading strategies that are profitable but likely to be skipped or ignored by those who have a fixed goal of specific income level at regularity.
For example, a very simple trading model that wins just 30% of the time but consistently generating 10% profit per year will not be considered at all by someone who is fixated on having $10000 a month income with just $5000 capital. Traders with a mindset of having a be-all, end-all solution right from the beginning to get to what they want will have their chance of success dropped to almost none. Limited capital, blindsided urge to make money quickly and not enough understanding of the markets one is dealing all stack up against the trader.
Compound growth takes time. It is especially time consuming at the beginning stage. The charts above illustrated the point clearly. It takes patience and willingness to trade the less competitive strategies so that you can survive long enough in the markets to grow yourself and your capital into a level that has long term survival bias.
Compound Growth The Right Way
The continuous compound growth approach as shown in many trading system advertisements is dangerous. It is not the best way to trade if your goal is long term survival in trading. The problem with continuous increase in bet size based on your total trading capital is that it is unstable. It is betting on continuous performance stability which is something you can never be sure of.
The better approach is to review and adjust trade size based on either fixed time interval or fixed number of trades.
For the fixed number of trades method, it is based on the concept that you need enough data points from your performance to justify an increase in your trade size.
For the fixed time interval method, it has to be long enough to cover enough number of trades to be meaningful.
By increasing your position size slowly and conservatively as your trading capital increases, you are not only giving yourself room for potential error. You are also giving yourself room to manoeuvre when your strategy fails to perform. Unlike a static environment, markets are dynamic and often change their characteristics overnight due to certain events or policy changes. You cannot control what will happen to the market but you have control over your money.
Compound Growth The Defensive Way
Leverage is a double edged sword. We use leverage to trade to make it possible to make (lose) money faster. As your trading becomes profitable consistently, it is time to consider reducing your use of leverage. It is not only a good idea. It is actually a necessity to stay profitable over time.
The main problem with trading is that we are dealing with uncertainty all the time. Any trading method we use and any trading model we rely on do not have a guarantee on their future performances. We are also part of this uncertainty because we change over time. We may not think or behave the same way 5 years or 10 years ago that can affect our trading performance significantly.
As the persons who manage our own capital, we are the risk managers with the job to monitor and safeguard against our trading style and ourselves. Since trading performance can fluctuate, the only way to protect our capital when the inevitable performance slump hits, is to reduce the leverage we use as our trading capital grow. This slows down the growth of your trading capital by a small factor. But it increases your chance of survival by many folds.
In general, once your trading capital allows you to trade multiple contracts or parts per trade, you should consider increasing the amount of money you put behind each contract. If you use 10 times leverage, you only put down $1 per $10 face value of the contract you hold. In the case of Emini S&P, putting up day trading margin of $500 at the current 1900 level is using 190 times leverage. It is very high risk. As your trading capital grows, it is important to reduce the use of leverage gradually.
The immediate reaction to this advice from many people is that it will stop them from making it. My response is that it will give them a much better chance to make it. The main reason for their negative responses is that the belief of compound growth is not ingrained in their minds.
I have provided a good example example in the earlier chapter, It Pays Being Conservative. It may not looks like it but the delay of increasing position size to confirm if one has really acquired better trading skill is effectively using leverage reduction to protect the trading capital.
One of my mentors, who was very old at the time I meant him, has a very nice analogy about the concept of compound growth.
In the grand scheme of things, trading is like growing apple trees. All the early efforts you put in do not show their effects until much later. You need to do many things right for years while watching your apple tree grows but no apple to eat. It is frustrating at times. It is also disappointing at times. As long as you set your goal straight and keeping the Apple tree healthy, you get to taste the fruits of your labour in 5 to 8 years.
The better effort you put in, the more likely your tree will give you apples in 5 years but it is not necessary. There are always the uncontrollable factors like bad weather and genetics. You cannot give up by the 5th year telling yourself there is no apple. You have to work diligently to figure out what may have gone wrong and fix the problems so that your apple tree will bear fruits one day.
Once your apple tree is strong enough, you can maintain the tree for more apple without worrying much. There are good times when you get more apples. There are bad times when you get fewer ones. As long as you do your part in protecting the tree, you know it will continue to reward you with more apples. When an apple tree is fully grown it can produce many times more apples than the first harvest.
For those with entrepreneur spirit, you can always choose to grow more apple trees after your first one is fully grown.