Have you heard of the economic term ‘velocity of money’? In effect, velocity of money is the rate at which money circulates, changes hands or turns over in an economy in a given period. High velocity means the same quantity of money is used for a greater number of transactions and is related to the demand for money. The velocity of money principle leads to potential for compounding by reusing the same money over and over again over a given period.
I’m sure all of you have heard of compounding, but are you aware that compounding achieved through the re-investing of profits (that is, reusing of the same money and the profits generated from using it) back into the market is ‘The Holy Grail’ of investing. Compounding will enhance your returns and grow your portfolio and capital substantially, if done correctly. “The most powerful force in the universe is compound interest.” Albert Einstein.
As profits are made from the market they add to the capital base and allow larger position sizes in subsequent trades to be taken. By implementing a strategy that encapsulates the turn over of the same capital in the market (i.e. velocity of money), you are in affect increasing the total amount of capital that is put to use in the market from which to generate profits.
To explain the positive effects that compounding can have on an active portfolio compared to that of a buy and hold type approach I have chosen to use the statistics of the Share Wealth Systems SPA3 ‘long only’ publicly traded portfolio.
A large part of SPA3’s long term success is based on the reinvestment of profits back into the market to create compounding. With an average hold period per trade of 8 weeks, SPA3 portfolios have continued to turn over portfolio capital on average of around 6 times per annum, i.e. a velocity of 6, depending on market conditions. This means that a SPA3 $100,000 portfolio should, on average, turn over its capital as though $600,000 per annum had been invested in the market. The more active any given strategy the greater the velocity of money. Whilst this is a phenomenon of all active investment strategies it is vitally important that the strategy has a positive edge or the componding can happen in the wrong direction!
From an initial $100,000 injection on January 25th 2001, the SPA3 long only portfolio has grown to $500,912 as at the 16th November 2010. Over this period the portfolio has completed 986 closed trades or an average of 100 trades per annum taking just 10 – 15 minutes a day to run the SPA3 processes. Overall these portfolio statistics equate to 17.87% compounded growth per annum or 400.85% total return on capital invested, including brokerage costs of $63,370 but not capital gains tax. By the way, over the same period the All Ordinaries has risen just 46.1%, or 4% compounded per annum!
The total amount of capital turned over through the market during the nearly 10 years is $13,385,913, or a total 10 year velocity of 133.86, that is the initial $100,000 invested has been turned over 133.86 times! From this velocity of 133.86, a total of $400,850 profit has been generated, after brokerage costs. This is a 2.995% return on the total capital put to work in the market ($13,385,913 / $400,850 * 100).
That is the power of compounding at work! To put it into perspective, let’s compare the SPA3 active investing approach to that of a buy and hold approach.
Take a look at the 400.85% return on capital invested. Remember this has been achieved by taking almost 100 trades a year over the last 10 years. Now let’s reset the clock back to January 25th 2001 and take the persepctive of a buy and hold or passive long term investor. Imagine picking 10 stocks, 10 years ago into which you were prepared to invest $10,000 into each. To achieve 400.85% on your initial capital you would have to have chosen 10 stocks that would each rise an average of 400.85%. That’s right, each stock that you chose 10 years ago, in advance, held through up and down markets would have to rise an average of 400.85%.
I challenge anyone, even with the benefit of hindsight, to find 10 stocks from the then ASX300 constituents that would have risen by this amount over the last 10 years! That’s in hindsight so what are the chances of doing so in advance considering the All Ordinaries has risen a mere 46.1% over the same 10 year time frame?
In addition, the 10 stock buy and hold return doesn’t take into account the inevitable loss trades that would appear in any private investor portfolio let alone large catastrophic loss trades that can happen. Stocks like Babcock and Brown, ABC Learning, MFS, One Tel, HIH plus many more were fundamentally sound companies at a point, but they are examples of what can happen in the markets when stocks implode.
Achieving compounding is key and can only be achieved through active investing with an edge and hence using the velocity of money to your advantage.