Wednesday, March 21, 2012

The Art of Speculation Series 2 - Differentiate between Investment and Entertainment


One of the main reasons why most market participants lost money in the financial markets is that they can’t differentiate between Investment and Entertainment. This is because financial markets can provide you with thrill, excitement, suspense, entertainment, sorrow, hope, heart attack, anxiety and fun at the same time. Due to the advancement of technology, you don’t need to leave home to be ‘entertained’ because all you need is a computer and an internet connection and you are in business. You can play it anytime of the day because there are more than 140 stock exchanges and 50 futures exchange for you to choose from.

It is unfortunate that many of the investors cannot draw a line between them. To them ‘Screen Staring’ is a must during the trading hours.  In actual fact the more you stare at the screen the more money you will lose because you tend to get emotionally involved. Once you can’t stop screen staring, then you need help because you have already cultivated what we called a ‘gambling addiction’.

Unfortunately such an attitude will not help you make consistent gains in the market because there will be many days of losing and winning during a month. At best an erratic performance.  Stock exchanges love speculators because they not only add liquidity to the market but also narrow the spreads and hence lower the cost of transactions. Besides, there are a whole lot of people that are dependent on this industry such as broking firms, stock brokers, marketing people, market analysts, fund managers, government bodies, regulators such as the Exchange and the SEC and so on. In other words it is an industry by itself.

Making money from financial markets is not an easy task because you will be competing with the best minds in the world. You are not only competing with farmers (like me), mechanics, bus drivers, housewives, fish mongers but also rocket scientist, lawyers, doctors, fund managers, market analyst, engineers and et al.

A lot of speculators have mistaken themselves as investors because they don’t understand the differences between speculation and investment.  In normal circumstances, the return on your long term investments will always be better than your speculations in the short term. This is because the costs of transaction, taxes, interest rates and others are very prohibitive.


The following tables show the result of three different scenarios on the effect of transactions costs, taxes, inflation rate and etc on your portfolio.


1) No transaction costs and inflation rate of 5% p.a.

Assumptions:

  1. Initial outlay - $100,000
  2. Annual returns -10%
  3. Transaction costs, taxes, interest rates and other costs - 0% per annum
  4. All returns are reinvested and no addition of extra funds
  5. Inflation rate is 5% p.a.

Table 1. Returns on 5% (10% - 5%)


Duration in YearsReturns in $
10
163,000
20
263,000
30
432,000
40
704,000
50
1,147,000



2) Transaction costs of 3% and inflation rate of 5% p.a.

Assumptions:

  1. Initial outlay - $100,000
  2. Annual returns -10%
  3. Transaction costs, taxes, interest rates and other costs - 3% per annum
  4. All returns are reinvested and no addition of extra funds
  5. Inflation rate is 5% p.a.

Table 2. Returns on 2% (10% - 5% - 3%)


Duration in YearsReturns in $
10
122,000
20
149,000
30
181,000
40
221,000
50
269,000


So as you can see from the above, both accounts started off with an initial outlay of $100,000 but the difference of just the 3% costs of transaction will indeed result in a substantial difference in the final outcome. You see the difference is $878,000 or it can be interpreted as savings of more than 300% of your money if you trade less.

The difference of $878,000 is what we called the ‘Entertainment Fees’ for getting our dose of ‘adrenalin fix’ when we go in and out of the market. So what will be the net result if we can reduce our transaction costs to 1 % instead of the 3% by trading less? The following table will illustrate the difference.

3) Transaction costs of 1% and inflation rate of 5% p.a.

Assumptions:
  1. Initial outlay - $100,000
  2. Annual returns -10%
  3. Transaction costs, taxes, interest rates and other costs - 1% per annum
  4. All returns are reinvested and no addition of extra funds
  5. Inflation rate is 5% p.a.

Table 3. Returns on 4% (10% - 5% - 1%)


Duration in YearsReturns in $
10
148,024
20
219,112
30
324,339
40
480,102
50
710,668


Again as you can see by reducing your transaction costs by another 2%, it will save you a substantial amount of money. The total savings is $710,668 - $269,000 = $441,668 which is quite substantial. Anyway the above figures can be obtained by using the Future Value formula.


FV = PV(1+k)n

Terminology explained.

FV = Future Value
PV = Present Value or original amount (in this case $100,000)
k = annual rate of interest rate
n = number of period (years in the future)


Our conclusion is, in order to be successful in investing in the financial markets, you need to draw a line between investment and entertainment. If you need to be entertained, I suggest you need to look elsewhere like drinking in a pub, sing your heart out in a karaoke, bungee jumping, rock climbing, play golf and other games. That’s what I do.

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