Investing for Long Term Security

Part 1

The most important item if you plan to invest, is to be a good steward of the gifts you are provided and invest wisely. If you are investing into any asset class, and decisions are based on this core fundamental and underlying basis, your investing will be secure and investing rewards will follow closely. Without following this reasoning, investing into property or shares turns into gambling and a un-needed leveraging of ones finances to a point where a minor market correction will create un-calculable losses.

So how do you create long term Security within your investing portfolio?

Hard work. Investing is like any other job. You work hard and smart and you get the reward. With your day job you work hard and your boss may or may not give you a pay rise or a bonus. The bottom line is the harder and smarter you work, it will increase your probability of getting a higher wage or bonus. Same with investing you work hard and the market may or may  not give you a profit. If you put in very little time to trading and investing you can only expect returns proportional to your input, and in most cases you will lose money. Trading and investing is a job. Viewed any other way your outcome and returns will reflect your input.

Firstly stop reading anything that is promotional and advertising based, be it on the internet or through papers, TV, radio etc. 99.9% of what you will read or hear about trading and investing will have an ulterior motive. In most cases it is a business pushing their own secrets, ideas, indicators, black box, programs etc. The normal story is "I have made my millions using this exact system and now, out of the love for society and humanity I am spreading the word and helping you the individual to also create untold wealth and cash flow and live happily thereafter. Just pay a small fee of 200$ and my secret will be shown you with ongoing day to day training provided etc. etc.". If someone is sharing anything with you that is not mathematically possible and fits within the average returns of what is possible profit to remove from the market,  it’s always bullshit. I hate to burst anyone’s bubble but there is no secret nor any strategy wall street has not heard about. It’s just sales and a flashy website. Put it another way, a trader or property investor may not be aware something is possible due to their limited education, but there are no secrets.

There are a lot of elements so we will break it down.

Capital Protection

Banks. 

Whilst this may seem obvious and redundant anyone who remembers the 2008 (or previous) Financial crises will remember banks going bankrupt. Is the bank where you hold your capital or where your broker holds your capital, have a good credit rating, and are they preferably be backed by the government in times of financial crises. Is the broker you are using holding your money in a separate segregated account or does your broker have access to your funds for hedging, trading etc to generate profit for the brokerage business. You want your capital in a Segregated account to ensure that if the broker goes bankrupt your assets can be returned to you.

Broker. 

What type of broker are you dealing with?

i) Market Maker broker (MM) - a market maker is a broker who makes the market on the other side of your buying and selling. With today’s technology it is very easy to setup a MM company and business. The core strategy of the MM business is to generate profit. The MM business know that 95% of traders will lose money. So based on that statistic they know they have a 95% probability of making profit every time their clients trade. In short, MM business core business profits, come from their clients losing money. Put another way, if the client believes they have a "special" strategy that will make money from a MM broker they will ultimately mean the MM company will lose money. As a business the MM will do everything in their power to ensure they as a business will not lose money. Same as any other prudent business owner in any field. So my question is, do you as an investor wish to be on the other side of a business whose core strategy is to make money from their clients losing money? Even if the trader is really good, how safe is your capital if you are trading to send the broker bankrupt?

ii) Binary Options. This is officially the scam of the century. For a mere $50k or less, a person can setup a binary options business. It holds the same risk and problems as the MM business except on a more obvious level. With MM at least they try to replicate the underlying investment instrument. With binary options there is no legal obligation to do this. It is too easy for the binary option backend algorithms to ensure that the business makes profit from its clients. This is exactly same level as a casino. Yes an individual may be able to generate a profit by playing slot machines once every now and again, but as a whole the house wins. The house has to win, otherwise the house has no business.

The only way to trade and ensure you are investing where the company/business on the receiving side of your trade is not making money from you losing money is trading market direct. Investing is hard enough without having your broker betting against you to loose. Let your broker make their money by simple transparent brokerage fee. Every investor has their own strategy some are long term investors, some are short term investors, some are going "long" the market some are going "short" the market, but the point is they are all trading the underlying value of the stock and profiting or loosing from its direct share price movement.

When selecting a broker an investor needs to ensure that they are trading the underlying instrument direct. Meaning if you are trading stocks like aapl, you actually are trading aapl direct and can get a shareholding certificate from your broker if required. If the investor is trading the futures market e.g. barrel of brent crude oil then then investor is trading the underlying direct. Whilst most brokers these days won’t let the investor receive the delivery of the underling  future, and will roll the futures contract forward to the next month(e.g. receive the actual barrels of oil at expiry) , the point is that the trader is trading the direct underlying instrument.

Forex  market. There are 2 ways to trade forex that is trading the market direct with the futures and options market, the other is through a forex online broker that uses ECN (electronic Communications Networks) and receives commission through spread (some of these brokers forfeit their spread and charge brokerage commission but it is still the same backend). There are 2 types of foreign exchange brokers, that are not futures foreign exchange contracts backed. One is MM which we have covered previously the other is ECN with straight through processing(STP). The ECN will have a direct link to any number of banks which will take the other side of your trade and provide liquidity to you the trader, and then in turn the broker will receive a commission from the widening of spread. So, whilst using a ECN broker with low spreads is an almost viable option, the problem lies in the fact that there is no actual exchange in this forex market so volume cannot be tracked as there are multiple ECNs using different banks through different brokers. This also means open-high-low-close prices vary depending on where you get your data from. To clarify there are traders who use this different potential pricing between ECNs to hedge and generate profits through the Spread between the different banks. It’s a game on a big scale, one you should not be looking into. If you trade foreign exchange the best way is to trade the futures market direct and using the futures options.

Trading is hard enough without having your broker taking the other side of your position and using that hedge, to generate a profit in order to stay in business.

When selecting a Broker be mindful of the pitfalls and how that will impact your financial security and also your ability to generate a profit.

CFDs (Contract for Difference)

 There are 2 types of CFD’s, one is direct market access (DMA) and the other is MM as discussed in point i. Point i provides enough information on the risks of mm services. If your broker charges you a brokerage fee per trade, and is not making money on the spread, and is DMA, this can be used as an effective hedging tool. Whilst not the same security level as  direct shareholding, DMA CFDs are an effective investment vehicle because a DMA CFD pricing is directly linked to the underlying instrument.

Now that we know our capital is not going to disappear due to some dodgy bank or brokerage business we can move onto strategy. Once a broker has been selected it is time to move onto how to be prudent investor investing into the underlying instrument’s an investor wishes to get involved in.

Leverage. A common reason why people go with CFDs and MM is the attraction of leverage for small accounts. If your reason for going with a broker is because of the leverage provided to your account, maybe your problems are bigger then this article can cover.

First is capital protection, second is trading underlying direct instruments and third is strategy. You need to be a profitable trader before you worry about leverage. If you can’t trade profitably on an ongoing year after year basis no amount of leverage will help you. Rather the opposite will happen leverage will ensure you lose all your money really quickly if you don’t have a solid and profitable trading strategy.

There is a lot of different strategies and concepts that are profitable if the investor is willing to put in the hard work. There is no free lunch.

Prudent Investing Points

Number 1.

Don’t believe anything any one tells you, believe only the outcome and proof you need to ensure the trade suits you and where you are at right now in your learning curve. If your broker says buy this stock, ask them why... and then prove it to me... and then what price are you the broker on your personal trading account going to buy this stock.... can you show me your share certificate to prove the purchase... are you telling me to buy because you have already bought the stock and need to sell to someone.... what price and when are you going sell... why... you get the idea. But this is life in general with everything you do, you need to question it.

I have a saying

" the results you get are based on the quality of questions you ask yourself" …. If you ask yourself crappy questions, you will then ask people questions that really are not worth a grain of salt, which in turn will reflect on your outcome.

Number 2.

Setting realistic expectations. The market both property and shares have only so much movement in them, meaning the market can only give you the investor a certain amount of return. If the benchmark ETF (e.g. spy for the US market) (ETF = Exchange Traded Fund) returned 10% last year and the top hedge funds returns were 15% in the same time period, why do you think that there is some secret that you can make 100% over the same time period. Is it not obvious that if it was possible to consistently outperform the relevant benchmarks by 10x that the hedge fund would be doing that? Hate to break the news but hedge funds have billions of dollars in net worth, they have teams of PhDs and Dr’s and other people that are a whole lot smarter than us, and yet their returns are still within the reasonable realm of possibility. That should be telling you something.

It is known that most floor traders and professional traders target about 18 to 20% per annum to cover costs. That is a realistic figure and anything above that is cream, but should not be expected as the norm.

I know it cliche but the core goal, is to be a prudent investor, and ensure your capital loss-risk, is minimized. Returns will naturally happen if this is done correctly.

Number 3. 

1. Invest into ETFs. I don’t believe in investing in a range of stocks to build a “diverse” portfolio and to “spread the risk” because we have seen from history that there is no benefit to this strategy. When you are a beginner, investing into individual stocks is fraught with danger and as an investor you need to be prudent with your capital. So investing into individual stocks is not prudent investing for a beginner. Rather what I am talking about here is investing into ETFs. The easiest way to protect your capital is via ETFs where ETFs are a pool of stocks. From a risk perspective if one stock goes bankrupt and no longer trades the ETF may go down in value but a traders position will not go down to 0$, this is due to all the other holdings the ETF own shares in are worth some sort of value.

2. Invest into non-correlated underlying’s. This means if one stock goes down in value the other will increase in value. This strategy itself will not specifically generate profits but will ensure that the capital of the investor is protected. One thing we have learnt over the last 5 years or so is that when the market crashes, everything falls in value. The old saying of diversification in stocks is no longer relevant, diversification is no use if all stocks fall at once as seen in 2008 market crash. Your portfolio also needs to be non-correlated.

3. Trade small. There is no specific size value but the point is to have a good understanding of the notional value of the underlying you are trading. If the notional value dwarfs your account balance you will have problems and your risk of blowing up your account is increased. A common strategy is using ES futures contracts to generate a profit, and you will hear a lot of new traders talking about their returns. Never mind their returns are calculated on their margin amount, not on the notional value of the futures contract. Should the market go against their position the losses will increase rapidly and turn into a large problem.

The rest of my blog covers actual strategies that you as an individual investor may find suitable based on your personal preferences.

Note: this article is about MM who make a market on synthetic manufactured underlying’s loosely replicating the underlying and whose core strategy is to generate profit from these. In the real trading world MM can provide a good benefit to the market in the form of providing liquidity to the market directly through the markets shares or futures contracts. High frequency trading firms also provide liquidity benefits to the market and are a strong asset to the business.