Investing can be a potent tool for individuals to increase their wealth over time. Compounding is the driving force behind exponential growth and has been dubbed “The Financial Miracle.”
Compounding occurs when investment returns are continually reinvested over time, resulting in exponential accumulation of returns. The longer an investor leaves their investment in play, especially during up-trending markets, the greater the impact of compounding.
However, there is a dark side to compounding.
‘Just as your gains compound when the market goes up, your losses compound when the market goes down’.
The good news is, there is a way of controlling this if you know how.
In this article, we explore the compounding effect in investments and how it works FOR or AGAINST investors. The magnitude of the compounding effect is greater for volatile assets like cryptocurrencies, where prices tend to yoyo 15x more than regular stocks or shares.
Compounding is an incredible concept with immense potential to generate substantial wealth over time.
For instance, suppose you invest $10,000 in a stock that earns a 10% return in the first year. In that case, your investment would be worth $11,000 by the end of the year. If the stock again earns a 10% return in the second year, your investment will grow to $12,100.
This is the beauty of compounding, where the return generated in the first year generates additional returns in the subsequent years, resulting in greater overall gains.
Over time, the compounding effect can creates substantial wealth, particularly when you don’t touch the investment during rising markets. For example, if you invest $10,000 and leave it for 30 years with a 10% annual return, your investment would be worth over a whopping $174,000.
While compounding can generate significant gains when markets go up, it can also work against investors when markets are going down. This is particularly true for volatile assets like cryptocurrencies.
For example, let’s say you invested $10,000 in Bitcoin in January 2017 when it was trading at around $1,000. By December 2017, the price had skyrocketed to almost $20,000, generating a return of almost 2,000%. Therefore, if you had invested $10,000 at the beginning of the year, your investment would have grown to almost $200,000.
However, the following year greater volatility struck, and Bitcoin lost more than 80% of its value, dropping to around $3,000 by December 2018. If you had held onto your investment, your $200,000 would have shrunk to around $40,000, wiping out most of your gains.
In an ideal world compounding flourishes when prices rise in series. However, we live in volatile times that creates a different dynamic; where prices rise and fall. In other words, money is made, and then lost. This naturally impacts the average returns.
Therefore, the greater the volatility, the greater the drop in compounding. Volatility kills the miracle.
The range of returns an asset can generate over a given period is referred to as the dispersion of returns. For volatile assets like cryptocurrencies, the dispersion of returns can be vast.
For example, in 2017, Bitcoin generated a return of almost 2,000%. In 2018, it lost more than 80% of its value. This wide dispersion can lead to significant gains or losses for investors, depending on when they enter or exit the market.
Now here’s the part most people forget or don’t understand about losses. When a market falls, negative returns have a much greater impact on your overall investment journey. The climb back up to recoup you initial amount is much steeper. For example,
if an asset valued at $100 loses 50% of its value, it needs to generate a return of 100% of its current value (ie. another $50), just to get back to its original value. If you lose 70%, you’ll need to claw back 233% to break even.
This demonstrates that negative returns actually have a bigger effect when compounded, leading to bigger losses over time, making it harder to get back to where you need to be.
Below is an illustration of the effect of volatility and negative compounding on two portfolios investing the same amount but with large yearly performance variations.
Let’s say investor A and investor B both started with 10,000 euros at the beginning of the year. Even though they both had the same average monthly performance, one investor, investor B, finished the year with 6 times the performance of investor A…..
And look at the numbers, this investor also took 40% less risk… how is this possible? Doesn’t makes sense right? Same monthly performance, 6x year performance yet 40% less risk!! It kind of magical right?
Investor with Portfolio A is a Buy&Holder, an inactive investor. So it took 100% of the highs and 100% of the lows.
The Investor with portfolio B employs Libertify’s Seatbelt, and active risk managed strategy which continually determines how much of the asset should be invested and how much should be held in cash. Libertify decreased the volatility of the portfolio by 40%, from 77% for the Buy&Hold to 47% for the Seatbelt investor.
This decline in volatility provides the investor with two big benefits. The first is that he feels at ease since his portfolio’s swings are considerably weaker. The second effect is that yearly performance rises from 4% to 25% because being largely in cash during market falls implies that losses are not compounded during the subsequent market comeback.
Libertify is a service that develops the crypto seatbelt, which is dynamically calculating the optimized exposure of each asset based on the market regimes and the risk profile of the investor.
This service can be beneficial for investors who want to invest in cryptocurrencies but want to mitigate the risks associated with the dark side of compounding.
The crypto seatbelt developed by Libertify uses sophisticated algorithms and machine learning to analyze market data and determine the optimal exposure to different assets based on the current market regime and the investor’s risk profile.
This means that the exposure to volatile assets like cryptocurrencies can be adjusted dynamically to mitigate the impact of negative returns and reduce the risk of significant losses.
The benefits of using a service like Libertify include the following:
Compounding is a powerful tool that can generate significant gains over the long term.
But the dark side of compounding is that it can also lead to big losses, especially if you invest in risky things like cryptocurrencies.
The dispersion of returns and the impact of negative returns can magnify the risks associated with compounding, leading to significant losses over time that become harder to recover.
Using a service like Libertify can help investors mitigate the risks associated with the dark side of compounding by dynamically adjusting the exposure to different assets based on the current market regime and the investor’s risk profile.
This can help investors maximize their gains while minimizing their risk, making it a convenient and effective option for those who want to invest in cryptocurrencies. So, if you are not managing your risks at all, or in a systematic, disciplined way, you may want to think again.