Deciding Between Self-Directed Trading vs. Managed Accounts
I have been in the financial industry for 25 years. It comes to my mind that many people do not know where and how to find proper investments for their funds to get a good and reasonable return. Instead, they are jammed or bogged down by the financial news in the stocks, bonds, or commodity futures markets. Some of them may even roll up their sleeves fully confident that they may be able to strike it rich!
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I write this article to let average investors know that proper investments for the future need to be well planned. You need to ask you selfd if you’re going manage your own money or let someone else do it? Different investment vehicles can determine the degree of decision making you have to do in order to maximize your returns. I will mention three general investment vehicles and their different characteristics and the rules and that govern them.
The investment games that people play
1. Stocks – in general have appeal to the public because if you invest in a good company, long term you may have a decent return on your investment, although it can never be guaranteed. You can be fully invested into a particular stock where there will be no financing involve. However, stocks that you invest in through brokerage houses will be able to lend you additional funds if you want to buy more. That in the investment world is what we call ‘margin’
For example, imagine ABC Company is trading at $100 per share, and you have $10,000. You can afford to buy 100 shares. However, in general, brokerage house will allow you to borrow money up to 50% margin, which means if you can pay $50 of 1 share of ABC Company the other $50 will be paid by the brokerage house, and now you can pay $100 by owning 2 shares. Of course, you will have to pay certain interest fees to the brokerage house for lending you the money. Therefore, instead of $10000 for 100 shares of ABC Company, now you have $20000 for 200 shares of ABC Company with a 50% margin money borrowed from the brokerage house.
Now if the stock increased in value to $130 per share in a few months, your $10000 fully paid investment at $100 per share will have $130 x 100 share = $13000. Your return is ($13000 – $10000= $3000, $3000 / $10000 = 30) 30%. But if you use $10000 and play with 50% margin, your $20000 margin investment will have 200 shares x $130 = $26000. Your return is ($26000-$20000=$6000 which will give you $6000 /$10000 = 60) 60%. You will have to pay some interest for the other $10000 that you borrow from the brokerage house. (For this example we ignore the commission and the interest.) So if you invest in a stock, you generally can use 0% to 50% maximum margin to get more bang for your buck! In this example, if you use it right, 60% return is always better than 30%.
2. Bonds – in general they are appealing to the public because if you invest in good company bonds or government bonds, they are always very safe and sound. However, it is in their interest that the corporation or government pays you back when it is mature. It is money you lend out and will get back in a certain date with high or low interest earned on your money. By rule of thumb, when the stock market is not in good condition, investors will be more in bonds than stocks because it is safer and earns interest with little to no risk.
If you invest in bonds, there are no margins that you can play. Usually you pay an amount that is less than round figures, and when you get it back will have the round amount as part of the interest earned. Now how do you find those corporate bonds or government bonds? Usually investors will be advised by the brokerage houses or banks to get different ratings of different bonds, and how much interest each specific bond pays. Higher risk bonds always pay higher interest, and low risk bonds pay lower interest to the investors.
To sum up this part, a Traditional Portfolio Theory is usually 50% Stocks and 50% Bonds handled by the Professional Managers.
3. Commodity Futures—in general they are little known to people except in times of inflation. When commodities such as gold, energy, or grains are moving higher, it affects people’s every day life. However, for the investment and trading purpose, it is the education part that blocks the investors. It is not as easily or widely accepted as the stock market. That is due to many reasons that I can explain further.
First, investors will probably not be interested in investing in 5000 bushels of corn due to ethanol’s rising demand and cost, or investing in rough rice as these prices rise as well. Second, investors are not getting used to what sort of news or information they can fall back on to know the particular commodity’s market trend. Third, in the commodity futures market is very common to play both ways, like to buy first and sell later to take a profit or loss; or to sell first and buy it back later to take a profit or loss. It is this part which is not a normal practice in playing stocks, as well as the concept that ‘you sell something when you do not own it first’.
Average investors have to understand the similarities and differences between stocks and futures. For example, say gold is around $900 dollars per ounce due to the depreciation of the U. S. dollar. Now to play the futures market, each contract is 100 ounces of gold, so if you want to invest in gold and are looking for it to go higher in the future, you will need $90000 ($900x100ounces) to invest in one contract of gold fully paid up. In playing commodity futures, if you can invest one contract (100 ounces) of gold, you can use around 0% to 97% of the maximum margin to play one contract. That is -in the commodity futures world- what we call ‘leverage’-which means you can pay 3% minimum (100% -97% maximum margins) to hold one contract of 100 oz. of gold in the market. That is $2700 ($90000 x 3% = $2700). This actually gives you a lot of room to adjust yourself comfortably as to how much margin you want to use.
For example, if you have $10000, you can hold one contract of gold. If the price of gold goes up to $1170 per ounce, so $1170 – $900 = $270 per ounce, this is an increase of ($270 / $900 = 30) 30%. However, when you calculate your amount of $10000 invested in that one contract of gold, it is equal to $270 x 100 ounce is $27000, your total return will be ($10000-$27000=$17000; 17000 / 10000 =170) 170%! This is because you are using 11% of the leverage—and using (100%-11%) 89% of the margin. ($10000 / $90000 per contract = 11.1%). Now assume you sell gold at $900 per oz. and the market moves down to $630 per oz. If you bought it back at that time and the difference is also $270 ($900 – $630), you will have the same results of return. It is your expectation of the price of gold in the future that counts! If you put up $90000 you will have 30% returns. If you put up $45000 you will have 60% returns. It is just the same as the previous stock example.
So Futures give you plenty of room to adjust to your investment habits, along with a good amount of market volatility. There are some basic differences between commodity futures and stocks. If you bought one contract of gold, you are paying a bone-fide deposit that at the future delivery date, you will either take delivery and pay the balance, or you can liquidate in the market any day before the delivery date and hold for another period of time.
To sum up all three above, a Modern Portfolio Theory is usually 37.5% stocks, 37.5% bonds, and 25% Managed Futures handled by Professional Managers and Money Managers. It usually reduces overall portfolio volatility risk and enhances performance.
Now you can try it for yourself, or maybe find someone to help along the way.
It is human nature that people think that they can do it themselves when it comes to trading and picking their own stocks. Especially nowadays, where opening an account from a brokerage house will get you all kinds of freebies, etc. I would say if you can do it, it is fine. It is easier when the stock market is in a bull market. But what about the bear or sideway market? That will test if you are really that good of an investor / trader. If you really do not spend the time and effort, it will be pretty tough.
This is where Mutual Funds come in. Their basic theme is TIME + MONEY = PROFIT! When it is a bull market, mutual funds will usually beat the return of the stock market index. If it is sideway market, mutual funds may be along the same line of the stock market index. However, if it is bear market; mutual funds tend to say they will lose less than the stock market index. So it is generally acceptable regardless of where the stock index is. As long as the mutual fund is down less than the stock index, it is still a good fund in a bear market. It is because history tells us eventually, TIME will help the MONEY invested and it will lead to PROFIT!
Professional mutual fund managers of course need to do good work to stay in the business. They have to know how to handle tricky situations. But for the average investor, you might just need to read their mutual fund performance record and their fees.
If you look at the Managed Futures, you will find that good Managed Futures basically reduce the overall portfolio volatility risk. That is why I mentioned that nowadays stocks can up or down 10% easily in a day, whereas commodity futures may not be able to do that. Stocks nowadays have a higher volatility than commodity futures. There are good Managed Futures products that have a reasonable return, year after year, regardless whether the stock market is in bull, bear, or sideway phase. This is because commodity futures are non-correlated to the stock market.
Managed Future money managers get paid by performance of the portfolio, which means they get paid by profit sharing up to a certain percentage. If they are not able to make a profit, they will not get paid, period.
Therefore, I think this just as worthwhile an investment as is a mutual fund investment. Futures money managers have to perform well in order to attract investors.
Are you debating over whether to be a self-directed investor or allow professional to do it for you?The following are some common differences between a professional trader and an amateur trader:
Amateur Trader
1. Often seeks instant gratification in the market
2. Often changes approach, takes quick profits, and lets losses run
3. Usually pays part-time attention to the market
4. May make decisions based on rumors, hunches, gossips, etc.
5. Believes to predict the direction of the markets rather than to manage risk
Professional Trader
1. Follows a sound trading plan
2. Limits losses and lets profit run
3. Pays full-time attention to the market
4. Makes prudent decisions and acts immediately when market signals come in
5. Utilizes prudent money management
6. Realizes capital preservation is a pre-requisite to capital appreciation
If you were able to be a successful amateur trader, year by year, for 10 years with an average return of 12% a year (that is what traditional portfolio return should be), in 10 years your average annual compound return should be around 230%! It is fine if you are able to spend the time, effort, and resources to make decisions on your own to achieve that goal, making sure that you use the proper money and risk management.
If you do not have the time to do it yourself, you may hire a professional manager as well as a money manager to achieve this for you. His past track record should show what kind of performance they achieved, although past performance is not indicative of future results. So if you have capital that you want to grow over the course of time, the question you should ask yourself is not necessarily, “What strategy should I learn and apply?” Also, consider asking yourself, “Should I management my own money or allow a professional to do it for me?”
Born in Shanghai and raised in Hong Kong, Patrick Yao is the President and Chief Advisor of YaoSun Strategic Investments, LLC (www.yaosuninvestments.com). He previously had a joint venture financial firm in China and taught in China’s Business University. He is currently registered with the Commodity Futures Trading Commission (CFTC) and is a member of the National Futures Association (NFA). Patrick can be contacted via email at pyao@yaosuninvestments.com.