There’s an article on the Time website titled Why Young People Should Buy Stocks on Margin that is worth reading. Mainly, it’s a Q&A with a pair of Yale professors who took a look at how the application of leverage in a person’s early years could positively impact their long-run retirement-building progress. The basic idea is that since young people, particularly those who are new working professionals, don’t have a great deal of investable capital they need to leverage up. Sounds like the thought process of many new forex traders.
Not surprisingly, the article is focused primarily on stock market investment.Â The profs also apparently suggest the use of double-long ETFs to get the type of leverage they suggest young investors apply. As a fellow blogger (I can’t remember who) pointed out in regards to the story, the leveraged ETFs have known performance issues when held over long periods of time. To quote the post I wrote following my L.A. Traders Expo visit last year:
You see, in order to match the daily performance of the underlying market, the ETF must be rebalanced each day. Depending on whether the market is trending or chopping, that rebalancing can actually produce over- or under-performance over a period of time exceeding one day. With that in mind, while it could be possible to boost performance in the right market conditions by playing the ETFs over a multi-day (week, etc.) timeframe, using them in expectation of seeing 2x or 3x matching of the market movement is not something you’d want to do.
That stuff aside, though, there are some valuable takeaways.
Taking the long-term view
The reason I think this article could be of some value to forex traders (aside from the implications it could have for how they handle their retirement) is in how it focuses on the long-run. That’s something too few traders do. They have a tendency to be locked in on today, this week, this month, or maybe this year. They don’t think often enough about 10 years or 20 years or 30 years out.
A very good example of the too-short-term focus is the way traders, especially new ones, tend to jump from strategy to strategy, system to system when they see a dip in performance. And they toss out systems which will produce decent results because they aren’t spectacular. In other words, they are looking to make a quick killing rather than steadily growing their assets over time.
Let me toss some figures at you. Say you start with $1000 and you have a trading methodology which produces 10% compounded annualized returns. In 20 years that $1000 will become about $6700. Doesn’t sound like a big deal, but let’s make things a bit more realistic and factor in additional investment along the way, which is what the Yale professors are looking at in their study. If you put in another $1000 each year at the end of the 20 years you’re up to about $64,000. That’s a huge difference, and keep in mind that you’ve only added in $20k along the way. The rest of the gains have come from compounded returns.
Open an Excel spreadsheet and run the figures with different variations of starting balances and periodic investments and you’ll quickly see that it doesn’t take a very high rate of annual return to accumulate considerable profits over time. If you’re a 20-something right now you reasonably have a 40 year investing window. Following the same $1000 start, $1000 annual addition, if you achieve a 13% compounded annual rate of return for 40 years you will end up with over $1.1 million. If you can put in $2000/yr it jumps to over $2.1 million. That’s not bad at all.
Take a look at the chart below to see how big an impact a few percentage points can make over the long-run.
Don’t Blow It
Of course building a big account over the long run requires not blowing up in the short-run. That’s what really does in so many new traders. They don’t fully grasp the risks involved in trading and end up making a foolish mistake somewhere along the way that severely hits their account. That means virtually starting over from scratch in many cases.
If you can avoid taking the big hit in the early days – either all in one shot or thanks to a lengthy run of negative trade results producing a large drawdown – then additional money put into your account along the way will be able to bail you out.
Using the $1000 start, $1000/yr addition from above, let’s look at what happens if you take a first year loss. A drop of 10% isn’t that big a deal because while that would reduce your balance to $900, the additional $1000 will leave you with nearly twice as much money as you started with, and only about 9.5% less than what you would have had if you’d made 10% instead. If you blow up your account, though, you’re $1000 annual addition basically means starting all over again and losing a year.
Take it slow
What all this means is that you should take it slow. It’s perfectly ok to start off making very small trades because if you’re thinking of the long-run you’ll realize that they are just one of what could be thousands upon thousands of trades you do over the years. Also, in the early years your account growth is probably going to come more from your annual deposits than from your trading returns. Of course this doesn’t speak to trading for a living, but if you’re a newbie with only about $1000 to start with you aren’t going to be trading for a living any time soon anyway, assuming that’s something you even want to do.