The Power of Compounding

Have you ever wondered why our mother kept nagging us to save money while we were young?  She might not be able to tell you in a scientific manner, but it's all about the power of compounding.

Let's compare the savings of 2 investors, Investor A and Investor B.  Investor A saves $20,000 each year from 28 years old to 65 years old (i.e. 38 years in total).  Investor B save $20,000 each year from 19 years old to 27 years old (i.e. 9 years in total).  Let's further assume that both of them are able to invest their money at 8% returns every year.  The following table shows the amount of money that Investor A and Investor B will get at the end of their 65 years old:      
 

Investor B starts saving earlier, but only for a period less than 1/4 of Investor A's.  However, Investor B will end up saving more money for his retirement at 65 years old.

Would you reconsider to start saving earlier?

The "Not-So-Simple" Rules of Trading

I still remember an interesting event that happened in October 2007 during the stock market mania in China and Hong Kong.  I was working in Beijing then.  The Shanghai Composite Index went up from 1071 in 8-Jul-2005 to 5903 in 12-Oct-2007.  In about 2 years, the stock market went up by about 5 times.  If you were to do a quick tour in the office, you would be able to see people surfing financial websites and trading stocks all day.  One of my subordinates, who was a certified accountant, decided to quit his day job and became a home day-trader.  Hmm....this sounded familiar to me.  When was the last time I came across this?  Oh, it was the dot-com stock market mania in 2000/2001.

It's conventional wisdom that when the shoeshine boys talk stocks, it was a great sell signal.  A modern version is when your colleagues / subordinates quit their day job and become a day-trader, it is a good time to get away from the market.  I sold off most of my stock holding in October 2007.  It turned out that this was one of the best things I had done for my investment.

I came across these rules of trading by Dennis Gartman a few years ago.  I believe most of them are still good wisdom in the world of trading and investing:

22 Rules of Trading

1. Never, under any circumstance add to a losing position.... ever! Nothing more need be said; to do otherwise will eventually and absolutely lead to ruin!

2. Trade like a mercenary guerrilla. We must fight on the winning side and be willing to change sides readily when one side has gained the upper hand.

3. Capital comes in two varieties: Mental and that which is in your pocket or account. Of the two types of capital, the mental is the more important and expensive of the two. Holding to losing positions costs measurable sums of actual capital, but it costs immeasurable sums of mental capital.

4. The objective is not to buy low and sell high, but to buy high and to sell higher. We can never know what price is "low." Nor can we know what price is "high." Always remember that sugar once fell from $1.25/lb to 2 cent/lb and seemed "cheap" many times along the way.

5. In bull markets we can only be long or neutral, and in bear markets we can only be short or neutral. That may seem self-evident; it is not, and it is a lesson learned too late by far too many.

6. "Markets can remain illogical longer than you or I can remain solvent," according to Dr. A. Gary Shilling.  Illogic often reigns and markets are enormously inefficient despite what the academics believe.

7. Sell markets that show the greatest weakness, and buy those that show the greatest strength. Metaphorically, when bearish, throw your rocks into the wettest paper sack, for they break most readily. In bull markets, we need to ride upon the strongest winds... they shall carry us higher than shall lesser ones.

8. Try to trade the first day of a gap, for gaps usually indicate violent new action. We have come to respect "gaps" in our nearly thirty years of watching markets; when they happen (especially in stocks) they are usually very important.

9. Trading runs in cycles: some good; most bad. Trade large and aggressively when trading well; trade small and modestly when trading poorly. In "good times," even errors are profitable; in "bad times" even the most well researched trades go awry. This is the nature of trading; accept it.

10. To trade successfully, think like a fundamentalist; trade like a technician. It is imperative that we understand the fundamentals driving a trade, but also that we understand the market's technicals. When we do, then, and only then, can we or should we, trade.

11. Respect "outside reversals" after extended bull or bear runs. Reversal days on the charts signal the final exhaustion of the bullish or bearish forces that drove the market previously. Respect them, and respect even more "weekly" and "monthly," reversals.

12. Keep your technical systems simple. Complicated systems breed confusion; simplicity breeds elegance.

13. Respect and embrace the very normal 50-62% retracements that take prices back to major trends. If a trade is missed, wait patiently for the market to retrace. Far more often than not, retracements happen... just as we are about to give up hope that they shall not.

14. An understanding of mass psychology is often more important than an understanding of economics. Markets are driven by human beings making human errors and also making super-human insights.

15. Establish initial positions on strength in bull markets and on weakness in bear markets. The first "addition" should also be added on strength as the market shows the trend to be working. Henceforth, subsequent additions are to be added on retracements.

16. Bear markets are more violent than are bull markets and so also are their retracements.

17. Be patient with winning trades; be enormously impatient with losing trades. Remember it is quite possible to make large sums trading/investing if we are "right" only 30% of the time, as long as our losses are small and our profits are large.

18. The market is the sum total of the wisdom ... and the ignorance...of all of those who deal in it; and we dare not argue with the market's wisdom. If we learn nothing more than this we've learned much indeed.

19. Do more of that which is working and less of that which is not: If a market is strong, buy more; if a market is weak, sell more. New highs are to be bought; new lows sold.

20. The hard trade is the right trade: If it is easy to sell, don't; and if it is easy to buy, don't. Do the trade that is hard to do and that which the crowd finds objectionable.

21. There is never one cockroach!

22. All rules are meant to be broken: The trick is knowing when... and how infrequently this rule may be invoked!

Buy, sell....or stay put?

Reference:

John Mauldin, Just One Thing: Twelve of the World's Best Investors Reveal the One Strategy You Can't Overlook (John Wiley & Sons, 2006).

Probabilities and Odds in Investment

Every day, you are able to see investment analysts in the television and financial columnists in the newspaper predicting the direction where the markets are heading in the coming hours, days, weeks, months and/or years. They are trying to tell you whether the market is bullish (i.e. going higher) or bearish (i.e. going lower). However, you need to recognize that you should not make your investment decision based on this information.

In his thought provoking book Fooled by Randomness, Nassim Teleb quoted an interesting story that cleverly illustrates the concept of expected value and the uselessness in predicting market direction. In a meeting with his fellow traders, a colleague asked Taleb about his view of the market. He unwillingly responded that he thought there was a high probability that the market would go up slightly over the next week. Pressed further, he assigned a 70% probability to the up move. Someone in the meeting then noted that Teleb was short a large quantity of S&P 500 futures - a bet that the market would go down - seemingly in contrast to his bullish outlook.  Teleb then explained his position in expected value terms:

------------------------------------------------------------------------------
Event                       Probability  Odd/Outcome     Expected Value
------------------------------------------------------------------------------
Market goes up         70%          Up 1%                 Up 0.7%
Market goes down     30%          Down 10%           Down 3%

                                                   TOTAL              Down 2.3%
------------------------------------------------------------------------------

In this case, the most probable outcome is that the market goes up.  But the expected value is negative, because the outcomes are asymmetric.

It is sad to note that people typically spend too much time and effort pursuing the higher probability events in making their investment decision, without even look at the odds.

Maybe there is a difference between gambling and investing afterall - most gamblers look at the odds before they put in their bets, while many investors do not even consider the odds when they invest their own savings (with much more money at risk) on a stock, bond, currency, and/or commodity. 

The Tote Board at the Hong Kong Jockey Club's Shatin Racecourse

References

Nassim Nicholas Teleb, Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets (New York: Texere, 2004).
Michael J. Mauboussin, More Than You Know: Finding Financial Wisdom in Unconventional Places (Columbia University Press, 2006).

Getting Started in Finance and Investment . . .

How do we usually start learning about finance and investment?

Most people start learning about them by watching television, reading newspapers and surfing finance related websites.  A friend told me that one was spending about an hour every day in reading financial news and stock recommendation.  My mother turns on her radio and television every weekday to track financial news, stock indices and share prices.  Indeed, there is an abundant supply of "financial advisors" and "investment analysts" in this world.  The key challenge is to identify the advices that you can actually trust, because most of these advices are contradictory to each other.

Some people start learning about finance and investment by talking to their stock brokers and relationship managers in the banks.  If these people follow the advices of their stock brokers and relationship managers, sooner or later, they will either buy and sell stocks more frequently, or they will put more of their wealth in unit trust and pension funds.  These are repeatedly proven to be bad investment tactics and approaches, due to their high transaction costs and management fees.  I always wonder how these stock brokers and relationship managers invest their OWN money.

For me, I was serious enough to study a master's degree in finance quite a number of years ago.  I was able to learn hundreds of financial and economic theories in the course.  The problem came immediately when I had to invest my own money: which of these financial and economic theories are genuinely useful in the real world?

This blog is created to share with other people about some of the lessons I have learned in finance and investment, and my journey in pursuing financial freedom.

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