Compounding is the process by which gains generate their own gains. When you earn a 2% return on a $10,000 account ($200), and you leave those gains in the account, the next 2% return is earned on $10,200 — generating $204. The extra $4 is modest on its own but compounding over months and years produces dramatically more than simple (non-compounded) returns.
The Compound Growth Formula
A = P × (1 + r)^n
Where: A = ending value, P = starting capital, r = return per period, n = number of periods.
A $10,000 account earning 2% per month compounds to:
- After 12 months: $12,682 (+26.8%)
- After 24 months: $16,084 (+60.8%)
- After 36 months: $20,399 (+104%)
- After 60 months: $32,810 (+228%)
Compare to simple returns: 2% per month × 60 months = 120% total return, or $22,000. Compounding produces $32,810 from the same 2% monthly return — the difference is the "interest on interest" effect accumulating over time.
The Enemy of Compounding: Drawdowns
Compounding requires a continuously growing base. A significant drawdown doesn't just cost you the loss — it sets back the entire compounding chain. A 20% drawdown on a $20,000 account (back to $16,000) erases over a year of 2% monthly compounding. The account must then recover that 25% (20% loss requires 25% to recover) before compounding resumes from the previous peak.
This is the mathematical argument for treating capital preservation as the highest priority. Not because losses feel bad — but because every drawdown breaks the compounding chain and requires disproportionate gains to repair.
Compounding vs Withdrawals
Compounding requires leaving profits in the account. Traders who withdraw all monthly profits are trading on a flat base — they capture linear returns, not exponential ones. If your goal is account growth, reinvesting profits is the mechanism. If your goal is income, partial withdrawal is appropriate — but the compounding effect on the remaining base will be proportionally smaller.