Debunking Myths 2 – Leakages and Negative Compounding don't matter?

Due to the level of competitiveness that investors are facing nowadays, it is important to take a second look at the cost of transaction and losses. Transaction cost may include brokers commission, government taxes, stamping fees and etc. This is because when you are investing, your main motive is to increase the return on your investment. The problem is that while you are winning someone else on the other side is losing. In a way it is very harsh out there, it is like a battleground either you win or they win.

Wealth Creation


Just to illustrate, what a mere $1000 savings from your brokerage commissions and government taxes can do to your personal wealth. We based on the following assumption

  1. $1000 initial investment
  2. 10% per annum
  3. don’t add or withdraw any money
  4. inflation not taken in

Table 1 – the effect of 50 years of compounding on $1000

Years Total Return
10 years
$2,590
20 years
$6,730
30 years
$17,450
40 years
$45,260
50 years
$117,390


So, you can see the effect of compounding on wealth creation. Even with small amounts saved by trading less in the markets will make a lot of difference in your wealth creation process. Empirical evidence shows that those who are engaged with hyper trading will almost ‘go home broke’,by the end of the day.

Important to know Negative Compounding


By understanding the effects of both positive and negative compounding improves your chances of success. A lot of investors are only concerned with positive compounding and neglecting the importance of negative compounding that will affect their portfolio.

In the following, we will show 2 different portfolios that will produce different returns even though they both achieve the same compound rate (200%), over a period of 10 years.

In table 2, we have a fixed income portfolio that produce 20% every year until the 10th year. No matter what happens to the economy, this portfolio will generate a 20% return throughout the duration of 10 years.

Table 2 – Fixed return of 20% p/a

Year Percentage %/year Total Return based
on $1000 investment
1
20%
$1,200
$1000 x 20%
2
20%
$1,440
$1200 x 20%
3
20%
$1,728
$1440 x 20%
4
20%
$2,074
$1728 x 20%
5
20%
$2,480
$2074 x 20%
6
20%
$2,987
$2480 x 20%
7
20%
$3,584
$2987 x 20%
8
20%
$4,301
$3584 x 20%
9
20%
$5,161
$4301 x 20%
10
20%
$6,193
$5161 x 20%
          Total = 200%
$6,193.00


The above Table shows the return of a portfolio with an initial investment of $1000 and with a yearly return of 20%, ended up with $6193 after 10 years of compounding.


The following Table 3, shows the same portfolio started off with an initial sum of $1000 and also with a duration of 10 years. The only difference is the rate of return, which is rather erratic, which gyrates between 50% and – 10%. You will see that the end result is much different at the end of the 10 years period.

Table 3 – Variable Returns on different years

Year Percentage %/year Total Return based
on $1000 investment
1
50%
$1,500
$1000 x  50%
2
-10%
$1,350
$1500 x -10%
3
50%
$2,025
$1350 x  50%
4
-10%
$1,823
$2020 x -10%
5
50%
$2,735
$1827 x  50%
6
-10%
$2,462
$2735 x -10%
7
50%
$3,693
$2462 x  50%
8
-10%
$3,324
$3693 x -10%
9
50%
$4,986
$3324 x  50%
10
-10%
$4,487
$4986 x -10%
          Total = 200%
$4,487.00


As your can see the difference between portfolio A and portfolio B is $6139 – $4487 which is $1706 which is quite sizeable. That is why a lot of people come to the wrong conclusion when both portfolios produce a 200% returns, somehow the monetary return will be the same. But the above tables show a different outcome, where Table 2 gives a better return than Table 3. How can this be?

The answer is, portfolio B have both positive and negative returns. In good years, it is compounding at a rate of 50% while in bad years it is compounding negatively at –10%. A negative rate of compounding will actually slows down the rate of return.

A good example is say a stock is trading at $100, if it experience a 50% drop, then the share price will be $50. In order to recuperate the $50 losses, the investor will need to achieve a 100% return on his $50 stock. This is the disadvantage of negative compounding because it need to work extra hard in order to play catch up with earlier losses. In other words, losses compound too.

This is why you need to use ‘Stop Loss’ orders if your stocks are going down, if not it will be doubly hard for your portfolio to regain its losses. Understanding this will have implications on your portfolio management because how often will you achieve a 100% return on your portfolio. In other words, you will need to learn how to keep your winners and discard your dogs.


On conclusion, understanding the power of negative compounding will help you in your selection of Mutual Funds and Dividend Yield stocks for your retirement portfolio. Especially in the Mutual Funds industry, the benchmark for performance is usually 3 years, 5 years and 10 years period. The problem is, the mutual fund companies only provide us with a lump sum figure as in xx % in say 5 or 10s year period. Normal investors will never know the breakdown of their earnings. They may earn a total of 120% over a 10 year period, but what good is it if it lose 8 and win 2 years? Negative compounding will work its way into the actual monetary gain. The same goes to Dividend yield stocks, as we prefer a stock with a stable dividend payout than another with rather inconsistent dividend payout.

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