A conversation arose recently regarding the idea of taking funds out of your trading account as a mechanism of providing yourself with a buffer. I have to state at the outset that I am diametrically opposed to taking funds out of a trading account except in the direst of circumstances. The reason for this is simple – compounding. Compounding is that old boring concept that traders in their fervour to be as modern and innovative as possible forget, yet it is the oldest of all the quantitative rules relating to trading and it is the most powerful.
In very simple terms taking money out of your account for whatever reason is the equivalent of giving your overall rate of return a haircut. Consider the table and chart below – these look at the long term growth of $100,000 at three differing rates of return, 20%, 22.5% and 25%.
It is obvious that the longer you leave the funds in at a given rate of return the more you make. But think of this in terms of taking money out. Whenever you take money out you are doing the equivalent of dropping back your rate of return. It might not seem as if the difference between 22.5% and 25% is that much but over time the difference is extreme. And this differential will only grow. However, there is a wider application to this notion and it applies to the holding of individual positions which often offer the opportunity for extreme compounding.
The chart above is of ALL with the 52 week new highs, a simple ATR stop and volume plotted – it is hardly rocket science. However, you will see that price has had an unbroken run from around a $1.00 to the current mark of around $22 – this run has taken about four years. If you look at volume you can see that it ebbs and flows but it is a constant – there are always people buying but more importantly there are always people selling. Whilst, it is impossible to divine the motivations of those selling it is fairly safe to say there has been no technical reason to sell this stock at any point in the past four years. The perfect world strategy would been to have simply let it compound (there is that word again). The mental gymnastics traders go through in justifying their decisions for selling is often extreme but in the end it often comes down to boredom – traders irrespective of their ilk have generally short attention spans and cannot stand the thought of being in a position for very long. Yet intriguingly this is how the true wealth is created.