Trading as part of an investment strategy

Investing funds into trading – either directly with a trader, or by renting strategies or investing into a larger trading fund – can be a viable diversification of an investment program. A small percentage of funds invested into trading can bring good returns. But the risks and should not be ignored.

Investment and Trading are not the same

Trading, per definition, is not investing. Investing is the purchase of assets because of believing that something fundamental will change their value, or that the business value of the investment will change. This can be the purchase of a good and growing company – like Microsoft or Dell where at a time. This can be the purchase of a house in a booming area, assuming that long term lack of housing will lead to an increase in value. Investment has generally a long term approach.

Trading, on the other hand, is the attempt to take advantage of price fluctuations because of a short term shift in supply and demand. Whether it is the purchase of oil because of the assumption a winter will be particularly hard, or the short sale of stocks assuming the Federal Reserve will increase the interest rates. Short term trading – Day trading or swing trading - go into small and micro market fluctuations of supply and demand, for example to make gains on the fluctuations caused by an investor buying a large amount of shares.

Trading as activity can be an investment

Still, for an individual or organization that has to manage a non-trivial amount of assets, an investment into a trading outfit, a trader’s operational funds or a trading oriented hedge fund can be a good investment. The possible returns in trading – especially for smaller outfits – can in percentage of capital invested – make any investment fund manager jealous. It is a lot more risky, though – as can be seen on the mandatory risk warnings that all trading investments have to show

Risk Disclosure: Unique experiences and past performances do not guarantee future results! Testimonials herein are unsolicited and are non-representative of all clients; certain accounts may have worse performance than that indicated. Trading stocks, futures, options and spot currencies involves substantial risk and there is always the potential for loss. Your trading results may vary. Because the risk factor is high in the markets trading, only genuine "risk" funds should be used in such trading. If you do not have the extra capital that you can afford to lose, you should not trade in the markets. No "safe" trading system has ever been devised, and no one can guarantee profits or freedom from loss.

So, why risk assets in trading? Because, like in any investment, the decision is one balancing risk and possible reward. Trading in itself is a risky strategy – but this risk can be controlled and contained with proper risk management techniques. If this is done, and the trading strategies deployed are sound and proven and well tested, then the return will make a nice addition to the assets. In addition to this, trading is relatively unconcerned with larger cycles and can provide income in times where the stock market is in a downtrend. It may not be enough – when the investment is small enough – to offset the losses on the investment side. But it can create a cash flow that can be used to offset living expenses or possibly even purchase additional investment assets.

Beware the risk

The risk warnings, though, are not there without a reason. Trading is risky, because emotions can make a trader behave unreasonable. And Greed – and ignorance of risk – can lead to an exposure that is unwise in an investment strategy. The general advice has always been to only risk funds that can be lost without seriously harming the investor. Depending on the stage in live and the income to assets ratio that maybe 5% to maybe 20% of assets – the later for a very young professional that has little assets but a good income stream, which is for example not uncommon with certain professions such as IT specialists. More established investors would be wise to keep exposure below the 10% mark.

A loss of those funds would surely hurt the asset total, but they would not create a significant hassle over the longer term. A good return of on invested funds will reduce the real risk relatively fast (because good parts of the profits should be removed until the initial exposure has been recouped).

An investor should definitely be very wary about any trader trying to convince him to invest a larger percentage of assets and should seek the advice of an investment advisor that is unrelated to any trading activity to determine the amount of funds that he can risk.

Critical trading Risks: Greed/Fear, Ignorance and really bad luck

Trading can create losses of invested funds mostly for three reasons, and two of them are to a large degree under the control of the investor. The third is actually bad luck. If a trader is short on oil, and for example a nuclear reactor explodes and the price goes through the roof – there is not exactly a lot that can be done. The same can be said for terrorist attacks.

The second reason is ignorance. Investing with a trader that is not able to explain how his strategies work, that cannot lay down a good risk management plan that is sound and based on accepted general mathematical principles. All this can be attributed to the due diligence an investor has to do himself – and many often fail to do. The last – but main – reason why trading ends in a loss of capital is often very human. The combination of two strong emotions – fear and greed – both on the investor side and on the trader side – lead to overexposure in the market. Either to “make more money” or to “recoup from a drawdown”. Taking aside possible criminal actions of a trader – because deviating from an agreed upon risk parameter plan is exactly this, criminal – it is often also the investor who is to blame for getting emotional about his investment into a trader. A drawdown is used as excuse to break the original risk allocation and send more funds to the trader – until sometimes nothing is left at the end. An investor should rely on a trader to do good explanations about his risk strategy, and then to look at it without emotions – possibly, if he is unable to do so, to delegate the overview over the trading investment to an advisor.

Trading yourself can be like being your own lawyer.

Working with a trader, though, has an advantage over trading oneself – there is a split in responsibilities. An investor trading his own funds is a lot easier to “get emotional” and breach risk parameters. History has shown over and over that a trader can, when things go bad, not be trusted to have good judgement.

Traders have often developed tremendous amounts of ingenuity to hide losses to avoid losing face. It is said, that being your own lawyer is a bad decision always. Often it is the same with trading. An investor is less likely to just “make the one trade to undo all losses” than a trader. In all cases, though, this is nothing else than a failure to establish a good separate party as risk manager. Once the losses pile up, the trader emotionally starts ignoring them. This is not possible for example with daily account statements. And the reason trading companies separate the trading from the back-office and risk management.

Obviously - a trader can go criminal

It is always a risk that a trader is going rogue. He can run away with the money (if he has access to them). He can take big bets way above the agreed upon limits. He can ignore risk and loss limits agreed upon and trade accounts to the ground. But the same is true for investments. Anyone remembering Roberd Maddoff will know that even large funds may be houses builds of cards, sending around fake account statements. Sometimes even brokers go so far.

At the end, this is normal risk – and an investor will also have to make his due diligence in this area. This is tricky – but for example with an individual trader, trading should be done on an account the investor controls. When money is pooled, very regular reports should not only be provided, but also be validated with the brokers.

Adding trading to an investment strategy: as good diversification

Trading can be a good addition to an investment strategy. It should be done with care and not more funds than can be risked without impacting the investment badly. See it as “a stock that may go bankrupt”. Due diligence should be a top priority when dealing with a trader or trading company. As should be a constant control of the trading success. Temporary losses, the so called drawdown - are natural in trading. But they should be run against a risk matrix that the trader provides and an investor should have a sound (especially in regards to his funds and the trader) approach if and when he is going to stop the trading. Do not let trading take you down. Use trading ad part of your investment strategy.