Since I’m still waiting for the market to shake itself out and hunting for clues as to where the sharks are hiding, I thought that I would just share with you some of my own philisophies of trading in the meantime. In particular, I will describe how I determine how much I want to trade.

For me, trading is about capital preservation first and foremost and then profits second. Now, capital preservation means keeping your spending power intact. And note that this is does not mean the same thing as money, because $100 30 years ago is worth a lot more than $100 today. Why? Because of inflation. That is why keeping your money under a mattress at home is the worst thing to do with your money. So for me, in order to maintain your money’s spending power, you have to make it grow at the same rate as inflation at the very least. Now the difficulty here is that asset classes like shares, property, interest rates etc. have their own cycles and so do not always outperform inflation, so it is important to be able to determine which assets are outperforming and which are not. Currently, bank interest rates do not, equities may or may not, and property definitely does. So if you are one of those investors who have managed to keep in line with inflation, then congratulations, you are succesful preserver of capital and your children will thank you for it. In Malaysia, most property owners who do not trades equities fall into this category.

Okay, now we come onto profits. Being able to generate proits is important because we wil invariably need to spend our money to survive. It is no good keeping up with inflation if you are going to be spending the money as well. So the equation I always use is: profits = inflation + spending. If you can make this balance then congratulations, you have attained a level of financial freedom which will allow you to retire today.

For me, this is the only benchmark worth thinking about. You can forget about outperforming the KLSE, or FD interest rates, or whatever. The only benchmark which will give you the true financial freedom you desire, is to outperform your own spending requirement.

Now let’s examine the concept of profit a little more closely. You can see it as something which is actually made up of 2 components: risk + reward. Risk is the level of danger you expose your capital (or yourself) to in order to get the reward. As law abiding citizens, let’s just look at it from the capital perspective. Would you be willing to risk all your money on a football bet? No? Because the risk is too great. Ok, would you be willing to risk half of your money on a football bet? Maybe? What about 1/3? and so on and so on. I always ask myself how much money I am willing to lose in order to see some profit. The general rule of thumb is that the reward must always be greater than the risk, and that the risk must always be below a threshold which I am satisfied with. That is why I always like to measure my portolio in terms of equity/cash exposure. Equity roughly approximates with my level of risk and cash is where I am not taking any risk. An extra dimension to this is also how long are you prepared to keep exposed to a particular level of risk? You might be exposed all the time because you want greater rewards, but are you happy to be in that state 365 days of the year? I believe that mental sanity is an important thing to keep in mind if you want to have a life, so you will find that at times your willingness to take risk will be greater or lesser than others.

So finally, once I know how much I spend, and how much I am willing to risk, I look at the reward and then I calculate how much trading capital I need to achieve that. If you apply that rigorous test to your own portfolio, it will become quite apparent how much money you need to trade.

Here’s another moral to the story: MOST PEOPLE UNDERESTIMATE THE AMOUNT OF MONEY THEY NEED TO STAY IN THE GAME. That is why they end up taking bigger and bigger risks. Very simply, a person with a portfolio of $10,000 and a profit requirement of $1000 will need to perform by 10%, compared to a person with a portfolio of $100,000 and a profit requirement of $1000. He only needs to make 1%. So you just need to take a guess as to which of these people will last longer in the market to figure out my point.

Have a great weekend all!