This article discusses the basic concepts and how to materialize and maximize compounding growth in the stock market.

A few days ago while I was stuck in the heavy traffic of Silicon Valley, I listened to a financial radio program . The host invited a real estate investor who bought a house 20 years ago. In the last 20 years, Silicon Valley housing market is booming. Then he started to talk about the extremely high reward of that investment, which he said it was doubled every year ! (Bad signal, I might have a bad memory). I immediately realized he must be joking and something must be wrong in his calculation. Assuming a $ 50,000 investment 20 years ago, 100 percent return per year after 20 years is: 1+100%）^{20} = 5×10^{10}, which is 50 billion dollars! OMG, that lucky guy just became one of the the world’s top 10 richest man by purchasing a house, too easy! For those neophytes, if he can follow a wise man who continuous double, after 10 or 20 years, would not be easy to become a millionaire or billionaire.

As can be seen, although the annual 100% return is not sustainable, but the use of time compounding long-term stable growth is the magic of accumulating wealth. Einstein once commented on compound rate:

“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”

Compound interest is that you reinvest the interest you earned each year and then take tat together with the principal investment, the absolute value of the growth rate of earnings faster. Einstein also discovered the Rule of 72, which can be simply estimate how long it will take to double for a give compound interest rate, here is the formula:

Years to double = 72 / Interest Rate

If the annual interest rate (APR) is 9%, then in the case of compound interest is calculated once a year, your investment will be doubled in eight years. You invest of $100,000 in the first eight years will become $ 20,000, and reach $ 1,580,000 to 32 years . If the annual income is 18 percent, you will get 20 million dollars after 32 years. 18% a year seems to be too easy, but it is not easy to maintain every year. Our goal is to achieve feasible, repeatable, scalable , low risk investment which we can maximize compound interest.

yr | 1 | 2 | 3 | 6 | 8 | 12 | 24 | 32 | ||
---|---|---|---|---|---|---|---|---|---|---|

0% | $100,000.00 | $100,000.00 | $100,000.00 | $100,000.00 | $100,000.00 | $100,000.00 | $100,000.00 | $100,000.00 | ||

1.00% | $101,000.00 | $102,010.00 | $103,030.10 | $106,152.02 | $108,285.67 | $112,682.50 | $126,973.46 | $137,494.07 | ||

2.00% | $100,020.00 | $104,040.00 | $106,120.80 | $112,616.24 | $117,165.94 | $126,824.18 | $160,843.72 | $188,454.06 | ||

3.00% | $103,000.00 | $106,090.00 | $109,272.70 | $119,405.23 | $126,677.01 | $142,576.09 | $203,279.41 | $257,508.28 | ||

4.00% | $100,040.00 | $108,160.00 | $112,486.40 | $126,531.90 | $136,856.91 | $160,103.22 | $256,330.42 | $350,805.87 | ||

6.00% | $100,060.00 | $112,360.00 | $119,101.60 | $141,851.91 | $159,384.81 | $201,219.65 | $404,893.46 | $645,338.67 | ||

8.00% | $108,000.00 | $116,640.00 | $125,971.20 | $158,687.43 | $185,093.02 | $251,817.01 | $634,118.07 | $1,173,708.30 | ||

9.00% | $109,000.00 | $118,810.00 | $129,502.90 | $167,710.01 | $199,256.26 | $281,266.48 | $791,108.32 | $1,576,332.88 | ||

12.00% | $112,000.00 | $125,440.00 | $140,492.80 | $197,382.27 | $247,596.32 | $389,597.60 | $1,517,862.89 | $3,758,172.63 | ||

18.00% | $118,000.00 | $139,240.00 | $164,303.20 | $269,955.42 | $375,885.92 | $728,759.26 | $5,310,900.63 | $19,962,927.70 | ||

24.00% | $124,000.00 | $153,760.00 | $190,662.40 | $363,521.51 | $558,950.67 | $1,321,478.87 | $17,463,063.93 | $97,609,912.89 |

- Feasible: non-professionals do not need to spend a lot of time and effort required to track more than 10 stocks, or time the market, passive or semi-passive management should be sufficient to ensure the reward. a.k.a to achieve the optimum reward on the time invested.
- Repeatable: That strategy can be used repeatedly, that is, when an indicator appears, according to the principles of the preset operation.
- Scalable: The performance of the strategy won’t be worsened with escalating cost if the scale of investment is increased. For example, for securities of the low liquidity, such as certain options and small-cap stocks, price can be go up or down drastically because we buy or sold transaction, leading to lower reward and a sharp rise of investment costs. Some strategies which is feasible when asset is $1,000,000 will become unpractical when the managed asset zoomed to $100,000,000.
- Low risk: return on investment is relatively stable, less ups and downs.

I would like to discuss the practical trading strategies to maximize compound rate from the aspects of steady growth, compounding frequency, security selection, dividend reinvestment, covered calls, short puts with intent to buy, taxes & fees.

1. Steady growth. Take a look at Berkshire Hathaway, S & P 500 and 2x S & P 500’s performance in this century.

BRK | SPX | 2xSPX | |
---|---|---|---|

2000 | 6.50% | -9.10% | -18.20% |

2001 | -6.20% | -11.90% | -23.80% |

2002 | 10.00% | -22.10% | -44.20% |

2003 | 21.00% | 28.70% | 57.40% |

2004 | 10.50% | 10.90% | 21.80% |

2005 | 6.40% | 4.90% | 9.80% |

2006 | 18.40% | 15.80% | 31.60% |

2007 | 11.00% | 5.50% | 11.00% |

2008 | -9.60% | -37.00% | -74.00% |

2009 | 19.80% | 26.50% | 53.00% |

2010 | 13.40% | 15.10% | 30.20% |

2011 | 4.60% | 2.10% | 4.20% |

2012 | 14.40% | 16.00% | 32.00% |

2013 | 18.20% | 32.40% | 64.80% |

mean | 9.89% | 5.56% | 11.11% |

Stdev | 0.091 | 0.199 | 0.398 |

compound rate | 9.51% | 3.60% | 1.64% |

Investment of $100K on 1/1/2000 | $356,880 | $164,135 | $125,560 |

Buffet’s (BRK.A/BRK.B) performance of these years is not as great as his heyday, but still quite outstanding comparing to S&P. Take a look at 2xSPX (this is just an analog 2x yearly performance, real 2x daily SPX ETF performance might be more volatile). In the past 14-year period, it rose more than 30 percent six times, only decline over 30 percent twice. The arithmetic mean of 11.11%, much higher than 9.89% BRK’s. But BRK 14-year compound rate was 9.51%, total revenue is + 256.88%, while 2xSPX the compound rate is only 1.64%, the total reward is only + 25.56%, and even worse than buy & hold treasury bond. Why? The answer on the standard deviation, in these 14 years, BRK never fell more than 10% once, there was only one year it rose than 20%, the highest increase was a mere 21% (I believe lots of investors can easily beat Buffet once, but may not beat him in a long run!). BRK standard deviation is 0.091, while 2xSPX drop more than 20% for three times, standard deviation is 4 time of that of BRK! It seems the problem lies in the fall, 2xSPX decreased by 74% in 2008, then what is the percentage it can rose to break even, remember: not + 74%, but a startling + 285%! That is continuous growth in 15 years at an annual rate of 9%! So remember Buffet’s famous quote: Rule No.1: Never lose money; Rule No.2:. Never forget rule No.1!

Therefore, without influx of fund, if the investment is wiped out, it would take almost forever to recover. So what kinds of securities can be surely forfitable giving unlimited time? As long as the money can pay interest or dividend, there is always a day the interest or dividend paid will surpass the principle! There are categories of interest or dividend yield investments, the risk from low to high, are CD (Certificate of Deposit)s, treasury bills, notes and bonds, municipal bonds, cooperate bond, Real Estate Investment Trust (REIT), utility stocks, preferred stocks, Master Limited Partnership (MLP) . We will discuss the pros and cons of various investment securities in the third part of the series.

2. Compounding Frequency

An overlooked factor is the compounding frequency. Stock or fund dividends can be paid yearly, quarterly or monthly. If every time the dividend reinvest, then the next dividend payment is will be calculated based on the latest principal, which is the sum of last dividend paid and the principal of the previous period, and that is compounded growth.

We will compare the APR (Annual Percentage Rate) 4%, 6%, and 8% with monthly, quarterly, annually compounding.

compound frequency | Annually | Quarterly | Monthly | Annually | Quarterly | Monthly | Annually | Quarterly | Monthly |
---|---|---|---|---|---|---|---|---|---|

yr | 4.00% | 4.00% | 4.00% | 6.00% | 6.00% | 6.00% | 8.00% | 8.00% | 8.00% |

1 | $100,040 | $104,060 | $106,136 | $100,060 | $1,061,364 | $1,061,678 | $108,000 | $108,243 | $108,300 |

2 | $108,160 | $108,286 | $112,649 | $112,360 | $1,126,493 | $1,127,160 | $116,640 | $117,166 | $117,289 |

3 | $112,486 | $112,683 | $112,727 | $119,102 | $1,195,618 | $1,196,681 | $125,971 | $126,824 | $127,024 |

6 | $126,532 | $126,973 | $127,074 | $141,852 | $1,429,503 | $1,432,044 | $158,687 | $160,844 | $161,350 |

8 | $136,857 | $137,494 | $137,640 | $159,385 | $1,610,324 | $1,614,143 | $185,093 | $188,454 | $189,246 |

12 | $160,103 | $161,223 | $161,478 | $201,220 | $2,043,478 | $2,050,751 | $251,817 | $258,707 | $260,339 |

24 | $256,330 | $259,927 | $260,753 | $404,893 | $4,175,804 | $4,205,579 | $634,118 | $669,293 | $677,764 |

32 | $350,806 | $357,385 | $358,899 | $645,339 | $6,724,398 | $6,788,405 | $1,173,708 | $1,261,310 | $1,282,639 |

As can be seen, if it is 8% APR, after 32 years, monthly compound has been higher than the yearly compound of more than 10%. Obviously, if APR is fixed, the frequency of dividend payment, the higher the ultimate benefits (higher APY). If a stock can pay dividend weekly or monthly, that will be ideal to grow compounding interest. If not, we can take advantages of covered call or diagonal spreads to enable the weekly dividend for ourselves.