Compounding: beyond numbers

I've been thinking about the topic of compounding lately, which Einstein famously considered to be the 8th wonder of the world (compound interest in this case). I haven't been thinking so much about the math itself, but rather about the mental dissonance that seems to exist between what compounding can do and how we perceive it - and in better understanding this dissonance, I plan to utilize lessons learned in how I set expectations in my own trading results. More on that later.

It's said that when evaluating a startup or say long-term growth company, people tend to overestimate the short-term potential and underestimate the long-term potential of the company. I think this may be explained by our tendency to fixate on absolute numbers, whereas a compounding mindset requires a shift to thinking in percentages. Absolute numbers are mentally satisfying, as we can immediately relate to what those numbers might mean to us, but percentages are vague and require extra steps to translate their meaning to the real world of absolute numbers. Compound returns are even more mentally taxing, requiring that we iterate these calculations and extrapolate results to a future point in time (and we know how much we love delayed gratification).

Also, by "overestimating", that can mean being too pessimistic as well as we yawn at small gains in the early stages.

For example, while there may be many "eureka" moments at the outset of a new venture or growth phase of a company, such as a proof of concept of a promising technology, it takes quite a bit of time and effort for that promise to become a significant money-maker. The "gains" in the early days may not look impressive on the surface, and may ward off potential investors as a result. The small revenue from early evaluations of the product is what many investors would probably fixate on instead of the potential for those evaluations to turn into real purchase orders later on down the road.

It takes a shrewd investor--and trader-- to fully appreciate the power of extrapolating percentage gains. Instead of thinking of how small those early gains look like from an absolute numbers perspective, it's better to think of how difficult it is to go from zero to one. What I gained from thinking about compounding is that it's absolutely essential to focus on expected gains from a percentage perspective. The absolute numbers will work themselves out. This is almost to say, "have faith in math". We can ward off psychological barriers by trusting the math, and of course doing some work in the background to ensure that the numbers are scalable (e.g. you run into liquidity issues pretty quickly with micro-caps, but a futures strategy can be scaled into the millions).

A good day, week, or month should not be defined by one's absolute returns, and the compounding mindset is the most valuable when those returns look measly in absolute terms (but meet the expected returns in terms of percentage). This is the secret sauce to sustained returns over time. In the business world, one can't help it but to focus on the business and let the numbers work themselves out. In trading, it's easy to deviate from one's risk management in hope of ramping one's account to a certain amount early on, or to get prematurely discouraged due to what appear to be measly numbers and abandon what could be an incredible long-term return once the compounding "kicks in" to allow our brains to register the impressive absolute gains we're seeing.