Category Archives: Compounding

Moving on to a Higher Table

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You’ve started to rake in regular profits on your poker table, or, if you will, on your regular trade-size.

Common-sense now tells you, that you need to scale it up a bit. After all, you’d still be risking the same percentage of your stack-size per trade. Simultaneously, if your win-ratio remains constant, you’d be allowing your stack to grow at a faster pace.

You move on to a higher table.

Welcome to the concept of position-sizing.

Those who position-size can evolve into huge winners in minimum time. Even though the idea of position-sizing is so central to trading, it is still one of the most under-discussed of topics. We need to thank Dr. Van Tharp for teaching this concept properly.

Think about it. When you win, your principal increases. On the next trade, you then put the same principal percentage at risk like you’ve always done. Because your new principal was more, it allowed you to buy more. Thus, you put yourself on the line to win more.

What’s essential here is also to down-size your position when you are losing. Taken a few bad beats in a row? Move down to a lower table for a bit, man. Allow your stack to recuperate at this lower level and then some before moving back higher. With that, when you’re losing, you start to risk less. Crucial point.

Of the different methods available to you to position-size, here, we speak about increasing trade-size when a new trade starts.

The advantage you enjoy when you’re doing pure equity is that on each new trade, your position-size can pinpointedly be adjusted according to your stack-size. Scale-up, scale down, trade upon trade, as the situation demands. Beautiful.

Why does this work out so beautifully for you?

You see, your system gives you an edge. You are opening your positions on high-percentage winners only. Period. Simultaneously, you are cutting your losses at your pre-defined maximum. You are also allowing your winners to win more. And, you are taking your stops. Even if your system then gives you a 55:45 edge over Mrs. Market, you’re doing great. Over a large sample-size (many, many trades, or for that matter many, many poker hands), your stack will increase with a high level of probability. As it goes on increasing, you keep turning on the heat by increasing your position-size further and further.

What happens then? What do you see?

Something beautiful happens.

Your trading principal (what we’ve been calling stack-size all the time) starts to increase exponentially. Have you seen the progress of an exponential function as one travels from zero to the right on the x-axis (the x-axis here would stand for sample-size or the number of trades taken)? If not, check it out on the net.

A good system should give you a 60:40 market-edge. In the Zone, you’d probably trade at 70:30 or beyond. That’s 70 winning trades out of every 100 taken, and 30 losing ones. Imagine what that does to your trading principal over 1000 trades, if you adhere to position-sizing, let your winners ride and take your stop-losses.

The numbers will boggle your mind.

Go for it.

The Power of Compounding

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At first, the power of compounding is a slow and steady trickle. Then, it starts gathering momentum. Finally, after a long time, it reaches epic proportions.

If you make the power of compounding work for you from as early an age as possible, you could well achieve financial freedom in your early- to mid- 40s. How does that sound?

Let’s say that your investment gives you a steady 8% per annum compounded. In 25 years, it us up almost 7 fold.

If the investment is giving 12% per annum compounded, in 25 years it will be up 17 fold.

15% per annum compounded – will be up almost 33 fold in 25 years.

20% per annum compounded – 95 fold.

27% (Warren Buffett’s average lifetime return per annum compounded, calculated some years before he donated his fortune to charity) – almost 394 fold.

42% (Rakesh Jhunjhunwala’s average lifetime return per annum compounded, that’s what they say) – 6415 fold.

What do you say to that? Don’t the figures speak for themselves and prove to you the power of compounding? Wouldn’t you like to start harnessing this power from like right now?

Let’s do another exercise. We are now looking at an investment term of 30 years. Other conditions remain the same.

An investment yielding 8% per annum compounded, in 30 years, will be up 10 fold, or a 1000%.

If the investment is giving 12% per annum compounded, in 30 years it will be up almost 30 fold.

15% per annum compounded – will be up 66 fold in 30 years.

20% per annum compounded – up 237 fold in 30 years.

27% – 1300 fold.

42% – 37038 fold.

Don’t the figures just blow you away? (They are so startling, that I have to ask myself if I’ve made some mathematical error. Why don’t you check these figures for me and inform me if there is an error).

The harnessing of this power of compounding is primarily the domain of the long-term investor. Nevertheless, the prudent trader uses it too. Such a trader ties up vast sums of money in fixed income investments for long periods of time, and then just trades on part of the yielded income, using the rest to live well and reinvesting what is still left.

It’s really time you start making use of the power of compounding. If not for yourself, then at least harness it for the futures of your children.

Asset Management is as important as ABC, or Multiplication, or Calculus for that matter…

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Imagine having lunch with a legendary investor like Warren Buffett. The first think he’ll talk to you about is the power of compounding. And when you say “Huh, what’s that?”, he’ll ask “Did nobody teach you about money management?”

And that’s the whole conundrum. Nobody teaches us how to manage money in school. Nor is this subject taught in college. We are left high and dry to face the big bad world without having the faintest clue about how to make our assets grow into something substantial.

Now why is this so? Is it that parents, teachers and professors worldwide have decided that no, we are, under no circumstances, going to teach our children how to manage their assets. No, that’s not the case. What is far truer is the fact that most parents, teachers and professors don’t know how to manage their own assets in the first place, so there’s no scope of teaching this art to others.

And do you know why that’s sad? Because youth is a prime time to sow seeds of investment that will grow into mountains later. When one is young, time is on one’s side. Salting away pennies at this stage puts into motion the power of compounding, a prime accelerator of growth. The time factor gives one tremendous leverage to deal with meltdowns, crises, calamities, catastrophes, recessions, depressions and what have you. As one grows up, one’s intelligently invested money has a very high chance of coming away unscathed and compounded into a substantial amount.

Don’t take my word for it. Just look around you. If you’ve been invested in the indices in India since 1980, your assets have grown 180 times in 30 years. That’s so huge that one is lost for words. This is despite all issues Indian and world markets have faced in these 30 years. All political crises, all wars, all scams, all corruption, everything. And, these returns are being generated by a simple index strategy. More advanced mid- and small-cap investment strategies have yielded many times more than these returns over this 30 year period. So just forget about meltdowns and crises, invest for the long-term, invest for your children, do it intelligently, and involve them in your investment process. Teach your children how to invest rather than making them cram tables or rut chemical formulae. Get them to take charge of their financial futures. Make them financially independent.

God has given the human being brains, and the power to think rationally. Let’s use these assets while investing. We’re looking for quality managements. We want their human capital to be working for us while we do other things with our time. We want them to figure a way around inflation, so that our investment doesn’t get eaten into by this monster. We don’t want them to involve our money in any scams. We want them to create value for us, year upon year. We want them to pay out regular dividends. Let’s inscribe this into our heads: we are looking for QUALITY MANAGEMENTS.

We are not looking for debt. The company we are investing into needs to be as debt-free as possible. During bad times, and they will come, mountains of debt can make companies go bust. There are many, many companies available for investment with debt to equity ratios which are lesser than 1.0. These are the companies we want to invest into.

We are also looking for a lucrative entry price. Basically, we want to buy debt-free quality scrips, and we want to buy them cheap. For that, we need to possess the virtue of patience. We just can’t get into such investments at any given time, but must learn to patiently wait for them. Also, we must learn to be liquid when such investments become available. Patience and timely liquidity are virtues that more than 99% of investors do not possess.

From Crisis to Crisis : Who said Investing was for the faint-hearted?

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The central focus while investing is on returns. Over the last 100 years, adjusted for inflation and tax-deductions, fixed deposits have given negative returns. And, over this period of time, the asset class of equity has yielded around 6 % compounded per annum (adjusted for inflation), which is more than 5 times what gold has yielded. There’s human capital behind equity, which strives to give returns despite inflation, and goes around taxes through legal loopholes. Gold is gold, there is no brain behind gold. It cannot evade the forces of inflation and taxation. Thus, equity is a higher yielding asset class. For those who don’t realize the value of a 6% compounded return per annum over the long run after adjusting for inflation, let me give you an example which might boggle your mind. Had the Red Indians who sold Manhattan Island to the Americans in 1626 invested their 60 Gilders (= sale proceeds, with the purchasing power of USD 1000 today) @ 6 % per annum compounded after adjusting for inflation, their principle would have been many times the total value of entire Manhattan today. See? In the world of long-term investing, one needs to be clear about the fact that the power of compounding can move mountains.

At the same time, drawdowns in the asset class equity are also the largest. During the 2008 meltdown, the likes of a Rakesh Jhunjhunwala saw his portfolio shrink by 60%. He took it without blinking, by the way. Why? Because equity is not for the faint-hearted. Steadfast investors know inside out that equity has given these returns despite two world wars, one great depression and many recessions / meltdowns. Today, there’s a crisis, and then there’s another crisis. One’s portfolio gets walloped from crisis to crisis, and needs to survive all crises to get to the good times. A potential USD 184 billion debt default looming in Dubai doesn’t shake the long-term investor. Why not? What if the potential debt default becomes larger, let’s say USD 1 trillion. Still nada. What’s the deal?

When a long-term investor puts money on the line, he’s willing to risk 100% of it. Why? That’s because in such an investor’s portfolio, there’s a whole range of scrips. Some go bust, others don’t do well, some remain at par, and a few outperform. Those scrips that go bust or yield below par have a loss limit of 100% of the principal. And the long-term investor has already termed this loss as acceptable as per the dynamics of his risk-appetite. What’s the outperformance limit on those of his scrips that outperform? None. They can double, triple, multiply even a 100-fold, or a 1000-fold or more over the long-run. 2 examples come to mind, a Wipro multiplying 300,000 times in 25 years and a Cisco Systems multiplying 75,000 times in 15 years. A steadfast long-term investor will strive to pick quality scrips with an edge, and will go into the investment at an opportune moment, such that the chances of these manifold multipliers residing in his portfolio are high. And, if 20% of one’s picks multiply manifold over the long-run, one doesn’t need to bother about even a 100% loss in the other 80% of the scrips. Not that there is going to be that 100% loss in this 80%, because these scrips too have been picked intelligently and at opportune moments.

So, what’s the best opportune moment to pick up a scrip? The aftermath of a crisis, of course. Such a time-period has something for all. Those who like buying at dips can pick up almost anything they like. Those who like buying at all-time highs can pick up the scrips that have been eluding them because these too will dip during a crisis. A crisis is not a crisis for the long-term investor. It is an opportunity.

The Difference between Investment & Speculation

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Investment is the low to medium risk art of conserving capital and protecting it against inflation, such that in the long run, capital appreciates. Speculation is the high risk art of trying to turn a small amount of money into a large amount.

Investment banks upon the power of compounding. It is an amalgamation of human, monetary and product capital, a combination that favours appreciation in the long run, not linear, but exponential appreciation, owing to the power of compounding. The key requirements are intelligence during scrip selection, patience and tolerance to allow multi-baggers to develop and blossom, and common-sense in handling one’s portfolio. Also, one needs to weed one’s portfolio at times, to remove poisonous scrips.

Speculation banks upon the power of leverage. This construct of finance is a double-edged sword. It can compound one’s profits, but also one’s losses. The speculator tries to cut losses and let profits run. This is easier said than done, because it goes against our natural instincts.

In the end, there are both successful and unsuccessful investors and speculators.

The key to deciding what line one should pursue here is a recognition of one’s own risk profile and appetite. What gives one sleepless nights? What is one’s pain threshold? How much loss can one bear without any effect on family life?

Such questions need to be answered before embarking upon either investment or speculation.