Compounding is defined by Investopedia as "the process in which an asset's earnings, from either capital gains or interest, are reinvested to generate additional earnings over time."
The traditional example of this is holding a single stock over a very long period. The constant reinvestment of the capital gains produces a compounding effect so you earn gains on your gains. This is the process that has made Warren Buffett an investment icon.
I'm not going to go into how fast assets can grow over time with compounding, but a simple example illustrates why you want to focus on it. A $10,000 investment earning 5% a year will be worth $26,533 in 20 years. If you can increase that return to 10%, the future value grows to $67,275. There are many compound interest calculators on the Internet that you can play with to get a feel for how the level of returns over various time periods has a profound impact on your results.
Most market participants think of compounding only in terms of a specific stock or in the form of a bank account where interest is constantly reinvested. The thing they overlook is that compounding is primarily a function of making sure that the assets you are investing in stay near their highs at all times. With a bank account, you don't have this problem. The dollars you invest don't go down in value, but with stocks that is the primary consideration.
Typically, people try to copy what they think Warren Buffett does. They buy just a few great stocks that they are sure will continue to rise steadily over a long period. In retrospect, it is easy to find things such as Apple Inc. (AAPL) , Microsoft Corp. (MSFT) and Facebook Inc. (FB) . It is a much more difficult process when you try it on a prospective basis. What stock can you buy today that will act as Apple has over the past 20 years? If we knew that with great certainty we'd all be on our yachts in the Caribbean.
The big risk with compounding is that you are in the wrong asset. Compounding works in reverse as well. Holding a stock that doesn't appreciate for many years is the more common situation that investors face and is extremely costly.
One way to reduce the risk of picking the wrong stock is to think of your portfolio as a single asset. It doesn't much matter what stocks you may hold at any particular time as long as your portfolio remains near its highs. That is how a trader can harness the power of compounding.
If you think of your portfolio of stocks as a single asset it changes your focus. Rather than just try to find a few good stocks to hold, you focus on carefully managing the stocks you do hold. Those that don't help keep your account near highs are eliminated and those that help it grow faster are added. If you do this effectively, your asset base will grow and the compounding effect will be of great benefit.
Obviously, this approach is more work than finding a single great stock to hold for a very long time, but it also reduces risk. If your account is going the wrong way, you cut your losses, regroup and look to find the stocks that will perform better in the future.
Most people fail at compounding their investment accounts because they suffer too many big drawdowns. They don't keep their accounts close enough to highs. They suffer a big loss and then must go through the very unproductive task of just returning to the point where they were.
Think about your portfolio as if it was a single asset that you are going to grow at a compound rate for many years. It doesn't matter what stocks you own or your holding period. What matters is keeping that account as close to highs as possible for a very long time.
