The Universal Investor. Speculation and Investment.
The purpose of this article is to emphasize the advantages and explain the logic of combining investing in different time horizons. Some thoughts on choosing the appropriate position size will also be presented.
We have received many messages from our Readers after publishing the previous essay about predicting corrections in the precious metals. We have been both praised and criticized for suggesting that using options might be very useful for gold and silver investors. The argument that is commonly used is that 'I am not a speculator, I don't gamble with my money, I stick to the long term'. In our view, investing in the long term is a very good idea, suitable for many investors, but it’s not the best idea. This essay is dedicated to explaining the logic behind the above opinion.
We think that the methodology used in this article may be applied to all markets, however it might be particularly useful to precious metals investors. In our view, the precious metals sector is characterized by a specific, cyclical nature and presents unique opportunities for speculators and traders. One of them was featured in our previous essay.
Usually when we take a book, brochure or even an essay written by an analyst or a salesperson who deals in investments, we see a host of hidden assumptions that are presented as facts. Some of them are easy to recognize like "this market is going to double within 3 next years" or "that company is undervalued" (based on just one method of valuation), some are much more difficult to spot. Usually author of a particular publication is advocating investing in only one time-frame. Rarely do authors combine different approaches towards investing. Partly, it's a matter of specialization, which enables individuals to focus on and master just one approach towards investing. On the other hand, however, it means that one is likely to miss out on opportunities that only combining strategies including different time-frames can provide. Authors often overlook this fact and state that "only investing long term can make you rich" or "in the long run we're all dead - investing short term is what you should do." Following analysis or advertisement is based on respective author's belief that one time-frame of investing is superior to the other. Such beliefs are exactly what was earlier described as "hidden assumptions".
Which of these assumptions are correct? Which are false? Neither? Both?
Generally they are both correct. The answer is more complex than it may seem at the first glance. There are numerous books on investing available to purchase for an individual investor. Some of them include strategies of different successful investors or speculators. Many of them made fortunes on day-trading, while others got rich thanks to buying early in the bull market and "sitting tight" all the way to the top. Some of these investors think that in the long term markets follow fundamentals, are logical and therefore predictable in that particular time-frame. Other, especially fans of the chaos theory, claim that only short-term price moves can be predicted with significant precision. The accuracy drops off substantially along with forecast's time. Both of these views seem to be supported by a group of successful investors. How can they be successful at the same time if they represent different views on such critical topic? The answer could be that some people are best in managing risk and their own emotions but on the other hand are not very patient, while others have exactly opposite skills. What is really important is how we can use techniques of both parties to optimize our own rate of return. People who speculate in the short term tend to limit the size of their position, even to a couple of percent of their total investment capital, while long term investors usually use a large share of their portfolio, keeping only a small part of money in the form of cash. Some of them invest all of their money. Again, are they really right at the same time?
One more time the answer is that they both could be right, depending on the potential gain of a given transaction and the probability that these gains would be realized.
For example, you might think that precious metals are going to appreciate at least for a couple of years (which is the case in our view), as there is a host of fundamental factors that give you that certainty. You can therefore invest much of your capital in silver and gold and wait for them to become more expensive. The upside is big, but not as enormous as in the short term transactions (annualized). Risk is limited as the whole transaction is based on logic and fundamental analysis. Simple, yet effective.
Short-term speculators usually do not care about fundamentals of particular market - they use technical analysis, daily news and more often level 2 quotes. The upside potential (let's say it's short term options) is usually several hundred percent in a few days or weeks, but the risk is also much greater than compared to long term investing. If you want to make money in this way, you need to keep the size of your position rather small. You might ask: "How small?" We will answer this question shortly.
The next question you might ask is, if and how can we make use of both strategies to boost our profits while keeping risk at the low level?
The answer is yes, we can. From a short-term trader perspective, we can use most of our cash reserves to purchase assets that have a very low risk on them. Long-term oriented investors can use several percent of their capital to speculate in the short-term. Results are the same, meaning that we get a portfolio of both short and long term oriented securities. Thanks to this approach, even if we are wrong on the short-term, we will still most likely profit on the whole transaction. Being wrong in the long term will probably not mean losing all capital employed in that transaction and possible losses are likely to be covered by profit from the short term transactions. Both speculation and investing are time-consuming activities but profits you gain are usually well worth the effort.
The final question is how do we choose the appropriate size of the short and long-term securities. The answer is a bit complicated, please bear with us, as we explain.
Usually, most questions can be answered through experiments, however in the investment business learning on one's mistakes can be a costly and difficult task. One reason is that often outcome of a particular action is known after days, months or even years. If, as a kid, you played ball in your house, broke a vase or mirror, and got somehow punished, you probably understood that you really should not have done it. However, if you played ball in your house, hit a vase, but it fell and broke 6 months later, odds are you would not associate it with the ball and would not learn your lesson. Unfortunately, investing is often the latter type of relation. Success of a given transaction is also result of many factors, including random ones. It is extremely difficult to know which factor was responsible for a particular reaction. Was this decision right and this is why this transaction is successful or maybe this transaction is successful because of some random every-day noise, DESPITE the wrong decision?
It's impossible to tell if you make just one transaction - you have to make a lot of them to test particular transaction. Other factors are likely to differ between transactions, so you may decide that it is better to make some kind of simulation of transactions instead of watching the real ones. It is possible and efficient if you can approximate the probabilities of outcomes. You could then "clone" a particular transaction and check what would happen to one's capital if he/she re-invested it using the same strategy each time. Thanks to this you could see what is the long term effect of this particular APPROACH. This is very important, since if you know that your approach is prudent and justified, then you will not get frightened if you occasionally lose a small part of your capital. Without that knowledge you could easily get discouraged to from a particular trade, which would most likely prove very profitable in the long run.
This methodology is even justified from a philosophical point of view. German philosopher Immanuel Kant stated that you should ‘act that your principle of action might safely be made a law for the whole world’. As investors we may adapt this thought by making sure that our decisions are optimal in the long term. That means ensuring that if a given transaction is repeated over and over again and we make the same decision every time, we would gain most.
For example, let's say that you have a 70% chance that you gain 100% on your capital and 30% that you lose everything. Expected value of this transaction (you can easily imagine, that this is a purchase of a short term options which you expect to double) is 70% * 200% + 30% * 0% = 140%.
Clearly it seems to be profitable. How much capital would you deploy to this scenario? Let's say that you have about $10,000 and decide to deploy everything.
Chance of winning is 70% so on average, 7 out of 10 transactions will be winning ones and 3 will be losing ones.
Table below presents likely outcome of using all of your capital each time.
As you see, the long term (here: ten transaction) outcome of this decision is losing all your money.
Now, let's say that you use about 30% of your money.
Although the first strategy gave you amazing $160,000 temporary, you end up with nothing. Second, more conservative approach, gave you total gain of about 115%, which is almost 8% per one transaction.
Please take a look at the following graph – it shows the relation between the amount of money (percentage-wise) you decided to invest in this simple scenario and the amount of money you would have gained after ten transaction (of which 7 would be winning ones).
Actually, the optimal size of your position is 40%. That would give you total gain of $12,769.32 which is about 8.6% per transaction. This is just a hypothetical scenario, but in reality you could put almost all cash from the part that you don’t use for speculation and put it into sound, long term investment. This could be stocks of senior gold/silver companies, a basket of juniors or the precious metals themselves.
On the other hand, if you are a long-term investor, you could boost your overall rate of return by putting only a small part of your holdings into more risky strategies. Naturally, we assume that these strategies are more profitable than the long term investment. Here’s an example:
The risky strategy is buying short (1 month to expiry date) term call options on gold or seniors gold companies and you assume that they have 33% chance of gaining 500%. We took a rather extreme example to better show you that even such transactions can be used, if the size of your position is appropriate. You decide that your maximum share of capital you will ever decide to use for short term trades is 30%. In this case, the long-term-optimal position size is about 16%. 16% of the 30% of your capital used for short term trades is merely 4.8% of your total capital. The average rate of return from this transaction would most likely amount to 2.5% - in terms of your total capital per month since we are writing about short term options. This means almost 35% of annualized gain. The 4.8% is the critical amount, so it still makes sense to use even 2% of your capital for this transaction, if the risk still seems to be too big for you. This approach would still give you about 15% annually. The point is that your long-term investment would not be greatly influenced but this strategy – after all 98% of your capital would not be used for it. That doesn’t look that risky after all, does it?
Important lesson that you can learn from this simple scenario is that at some point risking more capital does NOT give you more profit. That means that no matter how risk-tolerant and brave you are, there is a point when it makes no sense to increase your risk exposure, as it would decrease your profit in the long term.
Applying this methodology tells you exactly how and why long term investors and short term traders can be successful over time. For rather safe (95% chance of winning), long term transactions, which let you gain about 50% of your capital, this model would suggest using over 90% of your capital dedicated to this sector (precious metals in this case). This is exactly what most of long term investors do – keeping some powder dry, but investing a large part of their capital. Short term investors would most likely stick to risky strategies, as the one mentioned in the previous paragraph. This time it is prudent to invest only a small part of your holdings in each transaction.
Another thing is that you should think long-term even from a one-trade perspective. Combining single long-term-oriented transactions will give you a long-term-effective strategy. When entering a single trade you need to be comfortable with the amount of capital left after the money put into this particular trade is lost. This principle has already been found and successfully used throughout history. The legendary French ruler, Napoleon Bonaparte perfectly understood that you need to know your risks and take them into consideration before you get involved in particular action. "I accept I might be defeated, but caught in surprise, never" is one of his famous quotes. When we apply this phrase to investing, we must realize that we may lose a particular trade, but we have to be prepared for it.
If you want to know exactly how much money that should be, you need to use some tools to help you with that. You can easily make similar calculations, for example, using your worksheet program. Calculations for different time-frames are more sophisticated than those presented above. Whatever method of calculating the positions you use, you need to keep in mind the long-term effects of this particular strategy. As shown in the above example, you can have a profitable strategy from a 'one-trade' perspective, but if you repeat it and you invest too much money into a risky security you may end up losing money.
We have developed the Position Size Calculator, which gives special attention to long term success of your portfolio. It is designed to optimize a strategy between short, medium and long term options, however you can also use it to calculate positions in the short-term only – for example such as presented above. Register today and you’ll gain access to all our Tools and much more. We use the methodology described in this essay as well as many other techniques to forecast market’s moves and discover unique opportunities for profit. When you register, we will send you occasional, brief market alerts, based on our research, whenever situation requires it. Registration is FREE of charge and you may unregister anytime.
April 21-st 2008
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