Thursday, November 5, 2015

The Power of Compounding (Developing Your Plan IV)

The time to save for the future is now. Thanks to compounding interest, the earlier you start putting money away for the future, the more you will save.
Alexa Von Tobel

Unfortunately many traders and investors do not understand the simple concept of compounding. Their plan is written with goals that are blatantly unrealistic. The plans and the goals are more of a hope than a plan. If I can make X dollars then I can tell my boss where to go and live the good life. Whatever they perceive that good life to be.

Realistically you should understand the power of compounding; this basic principle is
essential in helping you initially set your goals, and keep them realistic. You can now work backwards from your end game to your current situation and plan. For instance if you invested $10,000 today at X% returns ( here is a Calculator) what would that $10,000 would be worth 3,5,10 and 20 years hence?

It should not surprise you that the higher the return, the higher the potential risks. What is your risk tolerance (how much of that risk capital can you afford, not only financially, but psychologically as well) to risk in order to attain your financial goals? I cannot overestimate the psychological part. It’s very easy to say I am willing to risk X% to make Y, but are you really psychologically ready? As an example and a true story; I once had a client referred to me when I was a commodities trader. He listed his net worth at $50 million exclusive of his home (this is 1970s dollars). I had thought I explained everything involved to both our satisfactions I evidently did not. I purchased for him one contract of an agricultural commodity. The market closed that day and he had a loss, on paper, of $200.

The next morning I received a call from this individual only to find out he couldn’t sleep the
night before because of the paper loss. Luckily I suppose, that market opened higher the next morning eradicating that minor loss and the position was liquidated. While this is obviously an extreme example it illustrates the point; your psyche and risk tolerance can and will affect how you go about things as it should. If you are risk averse, admit that to yourself. It merely changes how you go about trading/investing it doesn’t eliminate your trading/investing plan.

Before continuing; take the time to do some self-analysis. This is not an easy task; self- analysis rarely is. It will be time well spent. Keep a log, and in it write where you wish to be financially 3, 5, 10, and 20 years hence. How much capital do you have now, how much of it is risk capital, and how much can you contribute to the goal on a monthly or annual basis?

Your trading capital should be capital that you can afford to lose. I did not say be happy to lose, but if you lost it or a majority of it, your current lifestyle would not be affected, and in your opinion, the capital can be replaced within a reasonable period of time 

No comments: