The Power of Compounding
Strategies for super-sizing your returns and paying yourself passive income
You can increase your earnings potential by re-investing your earnings.
APR and APY are not the same, and understanding the difference is key.
The more frequently you compound, the higher your expected return.
Actively compounding rewards can max out your return, but can be more volatile and may not be suitable for everyone.
You can choose a compounding strategy, a passive income strategy, or a hybrid strategy.
The ACS Stake of the Week is Osmosis Pool #560 w/Superfluid staking enabled.
The Eighth Wonder of the World
Einstein famously once said:
“Compound interest is the eighth wonder of the world. He who understands it, earns it… he who doesn’t… pays it.”
To illustrate the effect of compound interest I am using a Compound Interest Calculator that starts with the following parameters and shows growth over years.
$5,000 initial investment
$150 monthly contributions
9% Average Rate of Return (stock market historical average)
In the first five years, you can see the initial amount reflected as a constant purple bar. You’ll also notice the growing blue bar which is a result of contributing the $150 every month. And finally at the top, you’ll see a small green bar which reflects annual earnings at the 9% rate.
Jumping forward another five years, you’ll see this pattern continue but the purple bar, the initial $5,000 gets relatively smaller because it is being eclipsed by the other two. In the 10th year, the interest earned (green bar) surpasses the total contributions (blue bar) for the first time.
Fast forward 20 additional years, and the chart looks very different. Now the interest earned is significantly larger than both the contributions and the initial investment, which can hardly be seen at all. But why?
The simple explanation is that for every year of earnings, the following year those profits also generate their own interest. So after year 1, the 9% earned is also earning 9%. You might be thinking great, but 9% of 9% is only 0.8%, and that doesn’t seem like much. In year 2, it’s not, and you’d be right. But give it enough time, and carry 9% forward each year and see what happens (9.8% earned in Year 2 then becomes 18.8% earning in Year 3, and 29.5% earning during Year 4, and on and on). Compound interest is therefore exponential (you earn more on the back-end) rather than linear (straight line up).
But what does it mean for crypto?
Crypto is great because it offers investors an option for fast-tracking their compound interest, especially when it comes to staking and mining. It is highly unlikely that crypto price returns will follow any sort of reliable average over time because it is still so new and volatile, compared with hundreds of years of history in stock exchange trading. According to some, they are getting into crypto mining rather than real estate because the can break-even on their investment sooner.
This is great because we can achieve long-term compound interest effects in a truncated timetable with crypto.
APR and APY - What’s the Difference?
When looking at historical return rates, the difference between APR and APY is HUGE. Huge as in, it could be a wide gap between the two (for higher APR’s), and huge as in, it’s a really important concept to understand.
APR or Annual Percent Rate essentially dictates the linear return rate, meaning if you don’t compound (re-invest) your APR earnings.
APY or Annual Percent Yield will tell you the rate of return if you do compound (re-invest) your earnings consistently. APY should always be higher than APR.
Annual yield rates are constantly in flux, so what you’re looking at is essentially the yield at a single moment in time, subject to change. For example, compounding would not work “as well” if the rates drop by a lot. But it works when they stay within a reasonable range consistently. Of course, for whatever crypto is earning you APR, price stability is a sine qua non (absolutely essential) and therefore only tokens that continue to demonstrate they are not consistently losing value over time is what we’re interested in. This is why the highest APR pools are not necessarily the best, and in effect could be some of the worst.
Compounding, or re-investing earnings, can be done whenever those earnings are available. For Osmosis, it is once per day. For some staking delegations other than Osmosis, it can be done at any point, because rewards are earned continuously. Other platforms, such as Sifchain, automatically compound your earnings continuously unless you choose to withdraw them at certain liquidity windows.
The more frequently you compound, the higher the possible return until you get to continuously compounding (E.g. every 6 seconds with Sifchain), which is the maximum potential when it comes to compounding. To illustrate this, review the chart below that shows the effect after one year of compounding at various different rates. The chart was designed to represent the effects of staking Sifchain, which was generating 165% at the time (it has since gone to ~200%).
Clearly, you can benefit if you compound at least monthly, and if you can compound more frequently than that you can really max out your annual return rate.
A falling token price will decrease your returns, or could even put you negative despite the yield, while a rising price can have quite an explosive effect on your gains. Of course we strive for the latter, but do not mind a flat or consolidating price since we will earn yield regardless. If for example, price were to double after one year, the ~400% return for bi-weekly compounding would in effect be ~800% in dollar terms 🤯
We’ve demonstrated why frequency matters, but that is only part of the equation. The real question is should you compound at all? And if so, when and how?
While there is no right answer to this question, it will be up to the individual to determine what is right for them based on their goals, objectives, risk tolerance, and needs. We’ll cover some of the major strategies, and again there is no “best.”
With this strategy you compound all of your earnings as often as you’re able to. While this will increase your theoretical maximum potential earnings, it could also expose you to the biggest drawdown on your holdings (value differential from peak to trough).
Strategy style = Very aggressive
because it means you stay fully invested and continue to re-invest
Earnings potential = exponential
Who it might be for:
A long-term investor who doesn’t care about short-term fluctuations
A trader with a strong tolerance to volatility and an iron stomach
An investor who chooses to take a relatively small portion of their portfolio with the goal of growing it as big as possible
YOLO traders who want to take chance at a moonshot
With this strategy you take all of your distributed rewards and either sell or exchange them for cash or something else, such as to spend or save. This will decrease your theoretical maximum potential earnings, but also your expected volatility; it also decreases the probability of a total loss since you collect or take profits as time passes.
Strategy style = Conservative-leaning
because it means you take profits on your yield at every opportunity
Earnings potential = Linear
Who it might be for:
A passive-income investor who wants to invest for cashflow
An investor that wants to combine yield strategies with outright investments by taking earnings and swapping them for another investment, such as stocks or gold
An investor who wants to participate in staking and liquidity mining but also mitigate their risk or take a lower-risk approach
Sometimes Compound and/or Compound Portion of Earnings
This is perhaps a hybrid of the first two and perhaps the most difficult because it requires the individual to make judgement calls as to when to compound and when to take profits on earnings. It could also follow a predetermined plan if the user chooses around timing and/or choosing to re-invest a set % of earnings (E.g. 50%) while taking profits on the rest.
Strategy style = Somewhat aggressive
Earnings potential = Exponential, but to a lesser degree than Always Compound
Who it might be for:
An investor with both passive income and capital appreciation objectives
A long-term investor who doesn’t care about short-term fluctuations but also wants to mitigate risk of total loss
An experienced trader who is comfortable making judgement calls as to when to re-invest and when to take some profits out
An investor with changing needs for passive income (E.g. They may wish to withdraw earnings in some weeks or months but not others.)
If you fall into category #3 or would like to, the goal would be to re-invest when prices are relatively low, hoping they’ll bounce back, and take profits when they’re relatively high, expecting them to fall later. But if you get the timing wrong, you could end up making things even worse than if you followed a programmed approach (E.g. alternate months, always take 40% of profits, etc.) So be advised this is an advanced and difficult strategy, but can lead to increased profits if executed properly.
A practical solution probably uses some combination, as you may want to apply strategy A to investment X and strategy B to investment Y, etc.
Angel City Stake of the Week
Last week’s stake was outright staking of ROWAN tokens (Sifchain blockchain), which were then earning ~165% APR. The APR is now yielding ~200%. The token has lost about 7.7% since last week, coming down to $0.155 from $0.168, which is in line with Bitcoin’s 7-day loss of 6.4% as well as that of the entire crypto marketcap (which lost $100B in the last week down to ~1.65T from ~1.75T). When factoring in an average stake rate of 182.5%, the rewards of 3.5% for the week bring the net one-week net change of ROWAN dollar value to -3.7% (-7.7% + 3.5% in yield), or an outperformance of BTC by +2.7% on the week (-6.4% vs. -3.7%).
This week’s stake is Osmosis Pool #560 (OSMO / UST) with Superfluid staking enabled. Osmosis price has come down significantly from its peak, and is currently at $3.83 at time of this publication. It could be due for a rally, having lost 55% in the last three months alone. As mentioned in our newsletter from a couple of weeks ago, a stablecoin-paired pool can be a nice pool to be in during market sell-offs, as half of the pool is in dollar-denominated UST (Terra USD). We previously covered the introduction of Superfluid staking as part of the Osmosis v7 “Carbon” upgrade back in March, so check it out if you missed it. For instructions on how to enable Superfluid staking, see our Dropbox, as well as more info from the team.
In the first photo above, the APR shown is the 14-day bonded without Superfluid staking enabled. With superfluid staking, the current APR is 80.4%. When compounded, this becomes ~123% APY!
Mike, ACS Founder